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Introduction: The Acquisition Game
Many managers were apparently over-exposed in impressionable childhood years to the story in which the imprisoned, handsome prince is released from the toad's body by a kiss from the beautiful princess. Consequently they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price they'd pay if they made direct purchases on their own? In other words investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses better pack some real dynamite. We've observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.
Warren Buffett, 1981 Berkshire Hathaway Annual Report
The 1990s will go down in history as the time of the biggest merger and acquisition (M&A) wave of the century. Few, if any, corporate resource decisions can change the value of a company as quickly or dramatically as a major acquisition.
Yet the change is usually for the worse.
Shareholders of acquiring firms routinely lose money right on announcement of acquisitions. They rarely recover their losses. But shareholders of the target firms, who receive a substantial premium for their shares, usually gain.
Here's a puzzle. Why docorporate executives, investment bankers, and consultants so often recommend that acquiring firms pay more for a target company than anybody else in the world is willing to pay? It cannot be because so many acquisitions turn out to be a blessing in disguise. In fact, when asked recently to name just one big merger that has lived up to expectations, Leon Cooperman, the former cochairman of Goldman Sachs's investment policy committee, answered, "I'm sure that there are success stories out there, but at this moment I draw a blank."
It doesn't make sense. For over thirty years, academics and practitioners have been writing books and articles on managing mergers and acquisitions. Corporations have spent billions of dollars on advisory fees. The platitudes are well known. Everyone knows that you should not pay "too much" for an acquisition, that acquisitions should make "strategic sense," and that corporate cultures need to be "managed carefully." But do these nostrums have any practical value?
Consider. You know you've paid too much only if the acquisition fails. Then, by definition, you have overpaid.
But how do we predict up front whether a company is overpaying for an acquisition -- in order to prevent costly failures? What exactly does the acquisition premium represent, and when is it too big? What is the acquirer paying for? These are the details, and the devil is in them.
This book returns to first principles and precisely describes the basics of what I call the acquisition game. Losing the game is almost guaranteed when acquirers do not realize that acquisitions are a special type of business gamble.
Like a major R&D project or plant expansion, acquisitions are a capital budgeting decision. Stripped to the essentials, an acquisition is a purchase of assets and technologies. But acquirers often pay a premium over the stand-alone market value of these assets and technologies. They pay the premium for something called synergy.
Dreams of synergy lead to lofty acquisition premiums. Yet virtually no attention has been paid to how these acquisition premiums affect performance. Perhaps this is because the concept of synergy itself has been poorly defined.
The common definition of synergy is 2 + 2 = 5. This book will show just how dangerous that definition is. Pay attention to the math. The easiest way to lose the acquisition game is by failing to define synergy in terms of real, measurable improvements in competitive advantage.
A quantifiable post-merger challenge is embedded in the price of each acquisition. Using the acquisition premium, we can calculate what the required synergies must be. Often this calculation shows that the required performance improvements are far greater than what any business in a competitive industry can reasonably expect.
By analyzing the acquisition premium, we can determine in advance when the price is far above the potential value of an acquisition. We can also show why most purported synergies are like the colorful petals of the Venus flytrap -- dangerous deceivers. But managers who analyze the acquisition premium and understand the concept of synergy will not get caught. They can predict the probability and the amount of shareholder losses or gains.
My claim is that most major acquisitions are predictably dead on arrival -- no matter how well they are "managed" after the deal is done.
The M&A Phenomenon Mergers and acquisitions are arguably the most popular and influential form of discretionary business investment. On the single day of April 22, 1996, with the announcement of the Bell Atlantic -- NYNEX merger and Cisco Systems' acquisition of Stratacom, over $27 billion of acquisitions were announced. For 1995, the total value of acquisition activity was over $400 billion. By comparison, in the aggregate managers spent only $500 billion, on average, over the past several years on new plant and equipment purchases and a mere $130 billion on R&D.
Acquisition premiums can exceed 100 percent of the market value of target firms. Evidence for acquisitions between 1993 and 1995 shows that shareholders of acquiring firms lose an average of 10 percent of their investment on announcement. And over time, perhaps waiting for synergies, they lose even more. A major McKinsey & Company study found that 61 percent of acquisition programs were failures because the acquisition strategies did not earn a sufficient return (cost of capital) on the funds invested. Under the circumstances, it should be natural to question whether it is economically productive to pay premiums at all.
Logically, we should expect that managers choose an acquisition strategy only when it offers a better payoff than other strategic alternatives. But there are several pitfalls inherent in acquisitions because they are, in fact, a very unique investment.
First, since acquirers pay a premium for the business, they actually have two business problems to solve: (1) to meet the performance targets the market already expects, and (2) to meet the even higher targets implied by the acquisition premium. This situation is analogous to emerging technology investments where investors pay for breakthroughs that have not yet occurred, knowing that competitors are chasing the same breakthroughs. However, in acquisitions, the breakthroughs are called "synergies."
I define synergy as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently. In other words, managers who pay acquisition premiums commit themselves to delivering more than the market already expects from current strategic plans. The premium represents the value of the additional performance requirements.
Second, major acquisitions, unlike major R&D projects, allow no test runs, no trial and error, and, other than divesting, no way to stop funding during the project. Acquirers must pay up front just for the right to "touch the wheel."
Finally, once companies begin intensive integration, the costs of exiting a failing acquisition strategy can become very high. The integration of sales forces, information and control systems, and distribution systems, for example, is often very difficult to reverse in the short term. And in the process, acquirers may run the risk of taking their eyes off competitors or losing their ability to respond to changes in the competitive environment.
Legendary and successful acquirers such as Cooper Industries and Emerson Electric have learned over time and implicitly understand the fundamentals of the game. But most companies make very few major acquisitions and often hire outside advisers to do the acquisition valuations (called fairness opinions). A Boston Consulting Group study found that during the pre-merger stage, eight of ten companies did not even consider how the acquired company would be integrated into operations following the acquisition. It is no wonder that often the acquirer loses the entire premium -- and more. Escalating the commitment by pouring more money into a doomed acquisition just makes things worse, perhaps even destroying the acquirer's preexisting business.
The objective of management is to employ corporate resources at their highest-value uses. When these resources are committed to acquisitions, the result is not simply failure or not failure. Instead there is a whole range of performance outcomes.
Shareholders can easily diversify themselves at existing market prices without having to pay an acquisition premium. My analysis in this book shows that acquisition premiums have little relation to potential value and that the losses we observe in the markets to acquisition announcements are predictable. What do acquiring firm executive teams and advisers see that markets do not?
The most obvious answer to this question is synergy, yet anecdotal evidence suggests that managers are somewhat reluctant to admit that they expect synergy from acquisitions. In the battle for Paramount, synergy became the embarrassing unspoken word. And Michael Eisner has stated that he does not like to use the "s" word regarding Disney's acquisition of CapCities/ABC. So why do these executives pay premiums? Is it that those who do not remember the past are thoughtlessly repeating it?
The 1980s set all-time records for the number and dollar value of corporate mergers and takeovers in the United States, firmly displacing the famous merger wave of the 1960s. More than 35,000 deals worth almost $2 trillion were completed during the 1980s, with the average size of a deal reaching over $200 million in 1988 and 1989. Advisory fees alone totaled over $3.5 billion in the peak years, 1988 and 1989.
The merger and acquisition field is well established. Since 1980, managers have allocated over $20 billion to investment banking and other advisory fees to help formulate and ensure the success of their acquisition strategies. In addition to professional advisers, there are academic courses: leading universities give week-long seminars to packed houses all over the world, and the American Management Association has an extensive program on M&A. Yet despite all of this advice, many fail.
As Bruce Greenwald, a professor at Columbia Business School has said: "Once you see the truth about something it is obvious, but there are many seemingly obvious things that simply are not true." Obvious but untrue advice and folklore about acquisitions has led to bad business decisions. Why in fact do some acquisitions lose more money than others?
Back to First Principles: The Acquisition Game A bad acquisition is one that does not earn back its cost of capital. Stock market reactions to mergers and acquisitions are the aggregate forecasts of investors and analysts around the world of the expectations of the value of the investment. What does it mean when these sophisticated capitalists bid down the stock of acquiring firms and bid up the stock of targets?
The theory of the acquisition game and the synergy trap is rooted in the Nobel Prize-winning research of Professors Franco Modigliani and Merton Miller (M&M). The M&M propositions and their pathbreaking research on valuation begin with the assumption that the value of a firm (V) is equal to the market value of the debt (D) plus the market value of the equity (E):
V = D + E.
Think of this as an economic balance sheet where the market value of claims (the debt and equity) is a function of the expected earnings stream coming from the assets. You can divide the claims any way you like, but the value of the firm will remain the same. In the words of Merton Miller, "Think of the firm as a gigantic pizza, divided into quarters. If now you cut each quarter in half or in eighths, the M and M proposition says that you will have more pieces but not more pizza."
The application of this principle is crucial to understanding what it means for acquiring firms to lose huge chunks of market value following acquisition announcements. When you make a bid for the equity of another company (we will call this the target company), you are issuing claims or cash to the shareholders of that company. If you issue claims or cash in an amount greater than the economic value of the assets you purchase, you have merely transferred value from the shareholders of your firm to the shareholders of the target -- right from the beginning. This is the way the economic balance sheet of your company stays balanced.
Markets give estimates of this range of value transfer through changes in share prices. The idea of the transfer of value is the stepping-off point for the development of the acquisition game. In short, playing the acquisition game is a business gamble where you pay up front for the right to control the assets of the target firm, and earn, you hope, a future stream of payoffs. But while the acquisition premium is known with certainty, the payoffs are not. What, then, is synergy?
Investors around the world have already valued the future expected performance of the target firm. That value equals the pre-acquisition share price. These investors' livelihoods are based on paying what the performance is worth. So synergy must translate into performance gains beyond those that are already expected. Simply put, achieving synergy means competing better. But in current hypercompetitive markets, it is a difficult challenge just to achieve the expected performance that is already built into existing share prices -- at a zero premium. What happens when we raise the bar?
Because markets have already priced what is expected from the stand-alone firms, the net present value (NPV) of playing the acquisition game can be simply modeled as follows:
NPV = Synergy - Premium.
Companies that do not understand this fundamental equation risk falling into the synergy trap. To quote G. Bennett Stewart of Stern Stewart & Co., "Paying unjustified premiums is tantamount to making charitable contributions to random passersby, never to be recouped by the buying company no matter how long the acquisition is held."
It is the NPV of the acquisition decision -- the expected benefits less the premium paid -- that markets attempt to assess. The more negative the assessment is, the worse the damage is to the economic balance sheet and to the share price. Folklore says that the share price of acquirers inevitably drops on the announcement of acquisitions -- but in a properly valued acquisition, that does not have to be true.
To visualize what synergy is and what exactly the premium represents in performance terms, imagine being on a treadmill. Suppose you are running at 3 mph but are required to run at 4 mph next year and 5 mph the year after. Synergy would mean running even harder than this expectation while competitors supply a head wind. Paying a premium for synergy -- that is, for the right to run harder -- is like putting on a heavy pack. Meanwhile, the more you delay running harder, the higher the incline is set. This is the acquisition game.
For most acquisitions, achieving significant synergy is not likely. When it does occur, it usually falls far short of the required performance improvements priced into the acquisition premium. Putting together two businesses that are profitable, well managed, and even related in every way is not enough to create synergy. After all, competitors are ever present.
What can a manager do with the new business that will make it more efficient for the new business to compete or harder for competitors to contest their markets? When the managers of Novell acquired WordPerfect for $1.4 billion, did they calculate what WordPerfect was already required to accomplish given the first bid for WordPerfect by Lotus for $700 million? Did they ask what Novell, the parent, could do to make it more competitive against the office suite products of Microsoft or Lotus? If they asked, their answers apparently left something out. Novell lost $550 million of market value on announcement of the acquisition. Since then, Microsoft has continued to gain market share and Novell recently sold WordPerfect, less than two years later, to Corel for less than $200 million -- a loss of over $1.2 billion.
A Brief History of the Research on Acquisitions Faced with the facts of acquisition performance, academics have struggled to explain them. The explanations fall into two broad categories: (1) managers attempt to maximize shareholder value by either replacing inefficient management in the target firm or achieving synergies between the two firms, or (2) managers pursue their own objectives such as growth or empire building at the expense of shareholder value. These hypotheses are an attempt to understand the average results of acquisitions and can be of use to policymakers.
Interestingly, there were good old days in the acquisition business. Research examining mergers from the 1960s and 1970s found that target firm shareholders on average experienced significant gains and acquirers either gained or, at worst, broke even. These results were consistent with the reasonable economic expectation that buyers would bid up asset prices to their fair value.
Then something went wrong. The evidence from the merger wave of the 1980s shows significantly negative results to the shareholders of acquiring firms upon announcement of the acquisition. These negative results extended beyond the initial announcement; shareholder returns declined as much as 16 percent over the three years following the acquisition.
The evidence documenting the destruction of value to the shareholders of acquiring firms came as no surprise to industrial-organization economists who for more than thirty years have studied the effects of mergers on issues such as accounting profitability, market share, and growth. The overwhelming evidence is that mergers do not improve profitability. Indeed, many studies show decreases in profitability at the line-of-business level. And these disappointing results hold also for market share and growth. These results are consistent with the hypothesis that managers are pursuing objectives other than wealth maximization for their shareholders.
Richard Roll, a finance professor at UCLA, explained value-destructive acquisitions with a dramatic template, suggesting that managers actually believe there are synergies that can be achieved from acquisitions but that they are infected with a classic tragic flaw -- hubris. They are overconfident and thus pay too much when they win a bidding contest. In this scenario, overinflated egos cause acquisitions to fail.
This type of proposition can generate great notoriety for an academic and is exactly what the popular press looks for: the chance to pin a big failed decision on the ego of a CEO. How do you explain the difference between a failed acquisition and a successful one? The CEO had a bigger ego. Yet the hypothesis fails to explain why the premiums paid over the past ten to fifteen years are as much as five times the premiums paid during the 1960s and early 1970s when acquisitions on average created value for shareholders. Are we to understand that managers today are five times more confident or have an ego five times bigger than it was during the conglomerate era of the 1960s? And what about big-ego executives who do not make acquisitions?
In the end it is impossible to test whether the hubris hypothesis or the hypothesis that managers simply pursue their own objectives is the true explanation. As Dennis Mueller of the University of Vienna so insightfully states, "Whether the premium paid actually represents the underlying beliefs of managers is inherently unanswerable in the absence of testimony at the time of the acquisition by managers under the influence of truth serum."
My objective here is to describe thoroughly what senior executives are getting their companies and their shareholders into when they enter the acquisition game, regardless of their motives. Reaching the decision to approve an acquisition is a complex process with a multitude of players, advisers, opinions, and interests. Major acquisitions are actually rare decisions for most companies. The problem is not necessarily hubris or even self-interest but may simply be unfamiliarity with the fundamentals of the problem. Acquisitions must be compared to other strategic alternatives. The real concern for managers is not the personal motivations of the players or the size of their ego but the mechanics of why the acquisition either works or does not work. What does the range of outcomes to acquirers mean? There have been many hypotheses, but no explanations.
Students of management strategy have focused on the factors that affect individual corporate performance. Professor Richard Rumelt broke new ground in the early 1970s when he found that firms with a pattern of related diversification had consistently higher accounting profitability than firms that diversified into businesses that had little relation to each other. Before this discovery, folklore held that "professional management" could be applied to any business, from helicopters to men's socks.
Management research in the 1980s wrestled with the question of whether related acquisitions outperform unrelated acquisitions. If Rumelt's hypothesis were true, then it was conjectured that acquirers whose business is more closely related to the business of the target should meet a more favorable stock market reaction than acquirers purchasing unrelated targets.
In fact, the evidence was mixed. Some studies concluded that related acquisitions were better than unrelated acquisitions, others that unrelated acquisitions were better than related acquisitions, and still others that the relationship just did not matter. So despite a decade of research, empirically based academic literature can offer managers no clear understanding of how to maximize the probability of success in acquisition programs.
The intrinsic problem with the literature is a lack of understanding of the meaning of the premium or the meaning of synergy. Instead of examining this problem, the acquisition performance literature in the management field has implicitly assumed the competitive markets' view that prices are bid up to their "fair" value. Within this model, gains may be merely a matter of luck, and losses are a matter of failed potential or mismanagement.
In other words, management researchers simply assumed that acquisition prices are highly correlated with potential value. Given this assumption, they could not consider the acquisition premium's potential as a predictor of post-acquisition performance. Thus, notably absent in all management studies to date is any consideration of the meaning or possible performance effects of the acquisition premium.
Because many researchers have assumed that the premiums represent fair prices in the beginning, a failed acquisition must have been the result of managerial problems such as post-acquisition culture clashes, morale problems, and leadership failures. The practical problem with this approach is that it does not realistically address whether the acquisition strategy could have worked even in the absence of implementation problems. It is wrong to assume that if the management problems were not there, all or any of the synergy promised by the premium would occur.
Whether acquisition premiums are fair values needs to be challenged. Because acquisitions are complex processes involving different levels of management, different political agendas, investment bankers, law firms, and accounting firms, it is altogether too easy for executives to pay too much. Many acquisition premiums require performance improvements that are virtually impossible to realize, even for the best of managers in the best of industry conditions.
The first step in understanding the acquisition game is to admit that price may have nothing at all to do with value. I call this the synergy limitation view of acquisition performance. In this view, synergy has a low expected value and, thus, the level of the acquisition premium predicts the level of losses in acquisitions.
For the past two decades, the premiums paid for acquisitions -- measured as the additional price paid for an acquired company over its pre-acquisition value -- have averaged between 40 and 50 percent, with many regularly surpassing 100 percent (e.g., IBM's acquisition of Lotus). Yet, as I show in Part 2 of this book, the higher the premium is, the greater is the value destruction from the acquisition strategy.
Restating the definition of performance, NPV = Synergy - Premium, we see that if synergies are predictably limited, the premium becomes an up-front predictor of the returns to acquirers. My objective is to explain the range of performance outcomes we observe, no matter how acquisitions perform on average. For example, in the sample of acquisitions from my study, the range of market reactions just on announcement ranges from a positive 30 percent to a negative 22 percent. Since the average size of acquirers in the sample is over $2 billion, we are talking about a significant range of changes in value.
If price represented value, then synergy would generally occur in the amount dictated by the premium. But suppose that price in acquisitions is not correlated with potential value. Further, suppose that potential is limited even in acquisitions where no post-merger problems occur. Predictions about overpayment up front would then be possible, and integration issues could be considered within a performance context.
In Chapter 2, I discuss the cornerstones of synergy to give a picture of what achieving synergy means and why it would naturally be limited in the absence of detailed post-merger strategies and clearly identified corporate parenting skills. And even then the intensity of the managerial challenge is imposing.
Chapter 3 examines the acquisition premium in detail. I analyze what I call the dynamics of required performance improvements (RPIs). The numerical simulations in this chapter give a picture of the actual performance requirements that managers face on a day-to-day basis following an acquisition just to break even. For various levels of the acquisition premium, we consider the "odds" of achieving the RPIs. Unless they consider the odds of payoffs in acquisitions, executives are merely playing craps with shareholder resources (worse -- because at least in craps, we know the odds).
Following the fundamentals of the acquisition game and the synergy trap developed in Part 1 of the book, I present a comprehensive cross-sectional study of the determinants of acquiring firm performance. Specifically, I ask four major questions:
1. Do corporate acquisition strategies create value?
2. Can the knowledge of the acquisition premium be used to predict the performance outcomes of an acquisition?
3. How do other factors (such as strategic relatedness, relative size, method of payment, mergers versus tender offers) affect performance in the context of the acquisition premium?
4. Will future risk taking by managers in acquiring firms be affected by the size of the acquisition premium?
Question 4 is posed to probe what may happen to acquirers after predictably falling into the synergy trap. Once they are caught in the trap, do they make matters worse by exhibiting gambling behavior?
This study is based on a sample of major acquisitions during the period 1979 through 1990. Each acquirer and target company was listed on the New York or American Stock Exchange, and the target was required to be at least 10 percent the size of the acquirer since my objective was to examine the effects of major acquisitions on the shareholder value of the acquirer. The average relative size of the acquisitions in the study was nearly 50 percent of the acquirer's value. Finally, the size of the acquisition had to be at least $100 million. Although approximately 80 percent of the number of acquisitions completed across the economy represent deals under $100 million in value, over 80 percent of the dollar value of acquisition activity is driven by acquisitions that are over $100 million in value.
I measure shareholder performance spanning seven different periods of time and using four different models of shareholder returns: (1) total shareholder returns (raw returns, commonly known as TSRs), (2) market-adjusted returns, (3) market- and risk-adjusted returns, and (4) mean-adjusted returns (returns relative to past performance). Past studies have used different measures, so I test my propositions against all of them. Fortunately, the major results are robust to these twenty-eight specifications of performance. Again, the objective is to understand what drives the range of performance no matter how it is measured.
The major results of the study support Michael Eisner's dislike of the "s" word. When other factors are held constant, the level of the premium is a significant up-front predictor of performance across all twenty-eight measures of performance. In other words, armed solely with the knowledge of the premium, any manager can give an estimate of how much money the acquisition strategy will lose and how much value destruction the shareholders of the acquiring firm will experience. From an outsider's perspective, I am offering an explanation of what markets see that managers and investment bankers do not seem to see.
Because the amount of losses can be predicted, these results go well beyond the winner's curse where bidders seem to overpay in auctions. And it makes no difference whether multiple bidders exist. (In fact, a potential acquirer should probably worry if no one else is bidding on the company.) I also demonstrate how strategically unrelated acquisitions can create more value than related acquisitions. Once you understand the synergy trap, this makes perfect sense.
There are fewer fairy-tale finishes than expectations out there, as Warren Buffett has related in the opening quotation to this chapter. The study strongly supports the fundamentals developed in Part 1 of the book. These fundamentals provide real tools for the real world, to enable managers to grapple with real problems.
There is a serious problem facing senior executives who choose acquisitions as a corporate growth strategy. My study reveals that fully 65 percent of major strategic acquisitions have been failures. And some have been truly major failures resulting in dramatic losses of value for the shareholders of the acquiring company. With market values and acquisition premiums at record highs, it is time to articulate demanding standards for what constitutes informed or prudent decision making. The risks are too great otherwise.
Falling into the synergy trap means losing the acquisition game from the beginning. There are many ways to l