Wednesday, December 19, 2012

Acquisition Alchemy: Creating value from deals

By now, it should be no secret that I am not a fan of acquisition-driven growth. I have argued in my previous posts that acquirers often pay too much, that many acquisitions are driven by CEO egos and overconfidence, that M&A bankers are too conflicted to give unbiased advise, that accretive deals can be value-destructive and that the presence or impairment of goodwill provides no useful information to investors.

Am I being too negative in my portrayal? Possibly. After all, there are companies have grown successfully with acquisitions, at least over some periods. In constructing a value-creating acquisition strategy, it is worth looking at what these successful acquirers share in common.

Go where the odds favor you
While acquisitions in the aggregate, and on average, have not been good news for acquirers, there are some subsets of acquisitions where  acquiring company stockholders do much better.

a. Small versus Large acquisitions: Acquiring smaller companies seems to provide much better odds of success than mergers of equals. In the graph below, for instance, take a look at the returns to acquirers around acquisition announcements of targets, with the targets classified based upon their size in market cap terms, relative to the acquiring company. Markets are much more welcoming of small deals than big ones, justifiably wary of the integration costs and culture clashes that mergers of equal inevitably bring.

Note that the biggest successes are with target firms that are small, with market caps, less than 6%  of the acquiring firm's market cap and returns get progressively worse as target firm size increases.

b. Cash versus Stock: There is no consensus finding here, but looking at the figure above, paying with stock seems to deliver higher returns for small acquisitions, but paying with cash seems deliver better returns with larger acquisitions. Perhaps, target company stockholders recognize the propensity of acquiring companies to pay with "overpriced' stock and demand higher premiums...

c. Private versus Public targets: Acquirers who focus on buying privately owned businesses rather than public companies earn much more positive returns, mostly because they don’t have to pay premiums over a market price that already incorporates much of what they are paying for. In fact, looking at the figure below, the very best targets are divisions of public companies, often divested at bargain basement prices by CEOs who want to get rid of high profile failures. (Quick: Someone make an offer to HP to buy Autonomy for a dollar…. They may take you up on the offer just to get rid of the albatross...)

d. Cost synergies versus growth synergies: While it is good to be skeptical about promised synergies in acquisitions, companies seems to be much better at delivering cost synergies than growth synergies, as evidenced in the figure below. This phenomenon may reflect the fact that cost synergies are easier to plan for and deliver than amorphous growth synergies.

Do your valuation, before you make your offer... and value all the "good" stuff
I believe that the biggest problem with an acquisition based strategy remains the price paid. If you pay too much for a target company, no matter how well matched that company may be to yours, you have a bad deal. The key to a successful acquisition strategy then becomes doing your homework in valuing not only the target company but all of the other goodies that you see coming with the deal, control and synergy being foremost. It is also critical that this valuation not be outsourced to bankers or consultants. They may be well intentioned, but it is not their money that is being spent. Here is the three-step process for valuing an acquisition:

Step 3: Value Synergy
Value the combined firm with synergy built in. This may include
a. A higher growth rate in revenues: growth synergy
b. Higher operating margins, because of economies of scale
c. Lower taxes, because of tax benefits: tax synergy
d. Lower cost of debt: financing synergy
e. Higher debt ratio because of lower risk: debt capacity
Subtract the value of the target firm (with control premium) + value of the bidding firm (pre-acquisition). This is the value of the synergy.
Step 2: Control Premium
Value the company as if optimally managed. This will usually mean that investment, financing and dividend policy will be altered:
Investment Policy: Higher returns on projects and divesting unproductive projects.
Financing Policy: Choose a financing mix/ type that reduces your cost of capital
Dividend Policy: Return unused cash, especially if you are punished for it.
Value of control = Target company value with optimal management - Status quo target company value from step 1.
Step 1: Status Quo Value (Target firm)
Value the target company as is, with the existing management’s investment, financing and dividend policy (even if it is optimal or efficient)

Each of these steps will require estimates and forecasts, but that is true for any investment. In fact, I would wager that many companies spend far more time making these assessments with small capital budgeting projects than they do with multi-billion dollar acquisitions. Managers will also claim that synergy is too qualitative and fuzzy to value, which would be fine if they were paying with qualitative dollars, but they are not. If you are interested, I do have more to say in my papers on the value of control and the value of synergy. You can also download the spreadsheets that I have to value control and synergy.

Get a share of the spoils
Just because you have valued control and synergy in a merger does not mean that you should offer to pay that amount as a premium. If you do, target company stockholders walk away with the spoils of your “hard” work (in delivering control and synergy value) and your stockholders get nothing. Thus, a key step in acquisition is negotiating for a fair share of both the control and synergy values. That fair share will depend upon how integral the acquiring company is to generating these additional values; the more important the role of the acquirer, the greater the share of the premium it should demand. In fact, if bankers are true deal makers, this is where they should earn their fees.

Have a plan to deliver the good stuff
While many acquirers seem to view getting the deal done as the climax of the process, it is really the beginning of a long (and often tricky) process of integration. Good acquirers not only have clear plans for what they will do after the acquisition but they also set aside the resources (people, funds) to put those plans into operation. When mergers work, it is almost never by accident. The KPMG surveys of global mergers over the years have emphasized this planning and post-deal integration as a key component to deal success.

Hold decision makers accountable
If you want acquisitions to deliver value, you have to hold everyone in the process accountable. I would start with the managers in the acquiring firm but I would also include the bankers and consultants to the acquiring company. In particular, I think that management compensation and deal fees should have clawback provisions that are conditioned on the performance of the merged firm (in stock prices and profitability).

Be ready to walk away
You have to be willing to walk away from a deal, if it does not make sense for you. In too many deals, the objective for the acquiring firm becomes getting the deal done, rather than getting a good deal done. In addition to staying disciplined, i.e., not going back and fudging the valuation numbers to make a deal look good, there is another simple rule that acquirers should consider following. If you get into a bidding war over a target firm, walk away. In fact, while you may nominally be labeled the “loser” in the bidding war, it is far better for your stockholders to be the loser rather than the winner, as evidenced by the figure below:

If being tagged a loser delivers a 65% differential return over being tagged a winner, as a stockholder, I will take the loser tag.

Bottom line
Creating value with an acquisition-based growth strategy is difficult to do, but not impossible. It requires discipline, planning and follow through, and few companies seem to have the capacity to deliver.

The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset


  1. Great series prof.

    Past is summed up: Deals are approved in advance (due to various reasons as noted) and analyses are done for back-up purposes.

    Advice for future: Will they take your advice? Well, what they learn from history is that they do not learn from history.

    But we learn from you prof.

  2. Dear Prof.
    A very good series indeed. Thoroughly enjoyed.

  3. Comprehensive series, Prof. How about deferred payment of Purchase Consideration subject to predetermined milestones, esp in tech companies where target co employees have a good holding?

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