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Saturday, 24 April 2010

Mayhem with M&A

Insane Acquisitions

Most company acquisitions generate significant benefits. Unfortunately these accrue almost exclusively to the shareholders of the companies being bought, rather than the owners of the acquiring corporation. Time and again major mergers and acquisitions fail to work yet this doesn’t seem to stop the cycle of value destruction. Yet again, something in the corporate world seems to be a bit broken.

The problem is that generally companies overpay for their acquisitions, diluting the value of their equity and, thus, damage the interests of their shareholders. Yet this is no secret, so company executives are persisting with their problematic purchases in the face of almost certain failure. Being insanely overoptimistic seems to be part of the human condition but being dementedly stupid isn’t an obvious precondition for managing major corporations. So what gives?

Be a Seller, Not a Buyer

Robert Bruner in Does M&A Pay? took a look at the research on mergers and acquisitions and concluded that the evidence for their general failure is more nuanced than the headlines appear. Most company takeovers don’t end up being value destroying, but most don’t actually make any great difference to the purchasers and Bruner argues that this shows that most acquisitions aren’t destructive of value. However, one can’t help wondering if this is really the case when you take into account the time, effort and general disruptiveness of a major acquisition: would management have earned better returns simply by concentrating on their own company?

Still, one group of people definitely do win – the shareholders of the companies being bought, whose returns are 20% to 30% over what they would otherwise have expected. Bruner’s research comes up with a bunch of interesting but largely expected findings. So takeovers that aim to create diversification, through the acquisition of companies in different business areas, tend to do worse than those that are more aligned with the acquirer’s core capabilities. This makes instinctive sense – managements should be expert in their company’s areas of interest so the closer these are then the more likely it is that post-merger management will be intelligent.

The Rules of Successful M&A

Other interesting evidence suggests that most post-acquisition benefits accrue not from increased combined revenue but from decreased combined costs: so-called synergies. Similarly, value based purchases tend to work extremely well, while glamour or growth purchases tend, at best, to offer very average returns and often extremely poor ones. No surprise there, then.

Perhaps one of the more interesting observations is that attempts to capture market position by purchasing competitors tend not to work. It’s not entirely clear why this is but there’s a suggestion that anti-competition authorities are actually quite good at stopping monopolistic tendencies amongst corporations, at least where they're as blatently announced as through a public takeover.

More pertinent, perhaps, is the research showing the ebb and flow of M&A activity with general market movements. Takeover activity tends to peak at or near market highs and usually collapses near the low points – which, of course, is exactly the wrong approach for companies looking to use acquisitions enhance value. There are multiple reasons for this – managements tend to be subject to the same emotional biases as normal investors and are likely to be more bullish when times are good and pessimistic during downturns.

However, managements have a different set of drivers from most investors – acquisitions require money and when markets are on their uppers there’s usually a distinct lack of cash around. It’s no accident that when debt becomes difficult to obtain and expensive to fund then stockmarket valuations fall. Just when managements should be really, really greedy they’re struggling to find finance of any kind.

52 Week Highs

Still, the odd prevalence of the 52 high week effect is now well documented and doesn’t appear to be anything to do with valuation. Simply put: the further in excess of the 52 week high an offer is pitched the more likely it is that the bid will succeed. Baker, Pan and Wurgler in The Psychology of Pricing in Mergers in Acquisitions also point out that the bidder’s shareholders seem to view a price at or above the 52 week high as overpaying by marking down the acquirer’s price.

What they think is happening – having tried to control for valuation effects – is that bidder managements and target company shareholders are getting anchored on the 52 week high price, largely because it’s a psychological trigger point for both groups. On the other hand, the shareholders of the bidding company have no such historical reference and hence take a harder look at the valuation of the target. That we find simple behavioural biases behind management merger logic should come as no surprise, but it goes some way towards explaining Bruner’s findings.

Buy High, Sell Low

However, the researchers have followed on from this research to investigate why we seem to see waves of merger at stockmarket peaks – although availability of debt obviously has something to do with it, they speculate that there’s more perverse psychology going on. What they find is that the difference between the current target share price and the peak over the past 52 weeks is critical. Selling shareholders want a premium over the 52 week high, acquiring shareholders don't want to pay much of an excess over the current share price: the net result is that if shares are trading near the 52 week high it's easier to justify the valuation to both groups.

This, of course, is just madness: the closer a company is currently trading to its most recent peak the more likely it is to be successfully targeted by a predator. No wonder value investors tend to run away from corporations that engage in major takeover activities.

The Human Factor

Having completed an acquisition managements are then likely to compound any mistakes by mishandling the human problems. To be fair, the ambiguity and uncertainty generated by a takeover means that this is always going to be difficult but there are underlying issues around the psychological concept of social identity that make this process a complete minefield.

Social identity is the concept that we anchor our identities by linking them to social groups: football clubs, political parties, racial groups and so on. Part of our social identity is bound up with our employers and those people who more closely identify themselves with their old employers are more likely to react adversely to a takeover. Again, this is exactly the opposite of what an acquirer would want – those people most likely to be highly motivated performers are those most likely to react badly to new ownership.

The general approach to reducing issues of social identity tends to revolve around creating an organisational vision with common goals and values. What doesn’t work is the new management explaining that they can now make much more money for shareholders. Unfortunately this is more or less what a lot of acquirers tend to be interested in, so the opportunities for conflict are pretty damn high.

No Abnormal Returns in M&A

Overall it’s easy to see why many takeovers don’t generate abnormal returns for the acquirer. The tendency to overpay based on psychological anchoring is a bad start and the subsequent need to justify the valuation to sceptical shareholders is likely to make the post-merger process quite traumatic. Worse, the post-merger trauma of social identity conflict is highly likely to result in many of the most valuable of the newly acquired staff voting with their feet.

Which, mostly, is what shareholders should probably do too. On the other hand, companies that make small, add-on purchases, often near market lows are probably well worth keeping an eye on. Value works, even for corporate purchasers.


Related Articles: The Psychology of Dividends, Buyback Brouhaha, Debt Matters

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