It's been an absolutely ugly October in global financial markets, and all indications point to continued uncertainty and volatility for the foreseeable future. Most CEOs and CFOs of public companies are looking dejectedly at company share prices that are a fraction of what they were just a year ago. For companies that are weathering the current storm, the question that progressive CEOs and CFOs will soon begin to consider, as they should, is, Where do we need to take our business in order to begin delivering shareholder value and returns once again?
Considering this question will require the crafting of a compelling narrative and strategy that these senior leaders can communicate to their employees, customers, and shareholders about what's next -- e.g., where is the company's future profitable growth going to come from?
One of the often-used vehicles to achieve growth, in theory, has been mergers and acquisitions (M&As); however, current market conditions make M&As a dicey or even impractical option. The unavailability of credit and increasingly expensive short-term refinancing rates, coupled with the economic downturn and depressed equity prices, have all served to make M&As difficult to accomplish. This has resulted in a spate of dead deals in recent weeks.
According to Deal Logic, the first 13 days of October witnessed 49 deals valued at $57.6 billion pulled, after $62.8 billion worth of deals were pulled in September. Acquirers that were hit by M&A travails include the BG Group, Waste Management, Bristol-Myers Squibb, HSBC Holdings, Dubai World, Xstrata, and Walgreen, to name a few. From this list, it is obvious that the M&A downturn is hitting companies in a diverse array of sectors, industries, and geographies.
How should CEOs, CFOs, and shareholders react to the M&A malaise? Contrary to popular belief, and especially so for those considering a large M&A transaction, they should pop open a bottle of champagne and celebrate. Why? Because according to our research, "megadeals" -- those in which the target's value exceeds $10 billion -- more often than not destroy shareholder value.
This is the underlying conclusion of our study in which we evaluated all megadeals from 2002 to 2007. We examined 33 M&A megadeals from Europe, Canada, and the USA in which the acquirers were strategic buyers -- not financial or private equity concerns. (Please note that because some data was unavailable, in some instances our results do not reflect all 33 deals; see the sidebar to get a list of the evaluated deals.)
In what was arguably one of the greatest bull markets we've ever seen, we observed that megadeals actually destroyed value over 60 percent of the time. On average, transactions resulted in negative cumulative excess beta returns (--4.03 percent) in the year after their announcement. (See the sidebar for insights into the research methodology.)
See large view of the chart here. [1]
Even among the handful of deals that generated positive returns, we found that success was more often than not attributable to macroeconomic factors beyond the control of the acquirer. So it seems that it is often better to be "lucky than good" or "in the right place at the right time" when undertaking large M&A transactions. Furthermore, the data shows that many of the deals, whether successful or not, increased the beta of the acquirer. Higher-risk profiles resulted in a higher cost of capital for the company post-acquisition, making such deals "costlier" in ways that can be very damaging to the larger entity over the longer term.
Following the quantitative analysis of all of the megadeals, we also sought to determine what lessons we could take away from the good, the bad, and the ugly so that future M&A megadeals can avoid past pitfalls and replicate elements of the few successful ones. However, before we do so, it is important to reiterate that our research showed few to no valid reasons to engage in megadeal M&As unless the desire is to redistribute shareholder money to needy investment bankers and lawyers. This being said, all the research in the world won't change the fact that people like headlines and deals are going to happen. Armed with this level of pragmatism, we developed a set of dimensions that should be considered when engaging in megadeal M&As.
Peeling Back the Findings
Regarding measures that you can control, here are some observations about how you can increase a deal's chances of success:
• It's important not to overpay. This is straight from the "master of the obvious" file, but it's clear that disciplined buyers outperform loose spenders. Evidence suggested that premium and performance are inversely correlated, meaning that the greater the premium, the worse the performance. By way of example, Boston Scientific's acquisition of Guidant involved a bidding war with Johnson & Johnson that resulted in Boston Scientific paying a handsome $80 per share as opposed to their original offer of $72. In the case of the Sprint Nextel deal, Nextel took advantage of Sprint's insecurity regarding its ability to compete against other carriers and as a result secured an excellent exit price. Both of these deals resulted in miserable excess returns.
In other cases such as Bank of New York Mellon's acquisition of Mellon Financial Corp., a very low premium was involved, as was the case in the CVS--Caremark and Manulife--John Hancock deals, which both did well. Price is not the only consideration, of course, but higher premiums generally make it more difficult for buyers to achieve high returns. The challenge ultimately is that when an acquirer pays a high premium, its shareholders get diluted or it uses cash to prevent dilution. The only way ultimately for the firm to get that cash back is to reengineer expenses out of the combined company. The synergies needed to pay for premium and the excess premium make this impossible. Moreover, the need to significantly reduce expenses can mean cutting muscle, not just fat, resulting in weakened competency and poor morale.
• Acquiring a faster-growth target is looked upon favorably. When companies acquire targets with higher growth expectations than their own, it appears that the market supports the acquisition. In contrast, when companies acquire targets that are underperforming and whose growth expectations are lower than their own, acquisitions tend to fail. In cases where both companies underperform and a transaction occurs, postdeal performance tends to be quite lackluster, as such an M&A is used as a poor replacement for an inability to generate organic growth. Unfortunately, combining two cubic zirconias rarely results in a real diamond.
• Mergers of equals outperform outright acquisitions. To determine the effect that the relative size of the buyer to the target has on M&A performance, we found that in general, acquisitions that fell in the Merger of Equals category performed better than those that fell into the outright Acquisitions category. Originally, this seemed slightly counterintuitive; however, a closer look at some of the best-in-class examples shows that in Mergers of Equals, both companies tend to have a fair amount of interest in deal success and thus are more collaborative. In Mergers of Equals, both companies often bring different strengths to the table and thus allow the whole to be greater than the sum of the parts. For example, when Manulife Financial Corporation acquired John Hancock Financial Services, the former provided strong brand recognition, while the latter offered strong access to capital markets, and both presented distinct distribution channels.
M&A Megadeal Success
Through research into individual transactions, we determined that high-performing deals considered the following dimensions and questions.
Practical Considerations:
- Macroeconomic and industry factors. Am I appropriately considering macroeconomic factors on the upside and downside that could impact the industry and/or competitive landscape? Are my expectations for future growth of the target reasonable, and is the deal worthwhile even in a worst-case scenario?
- Timing. Are there internal concerns that should take managerial priority?
- Price. Am I being disciplined in my determination of the price?
- Cost savings and revenue synergies. Am I comfortable that the deal is attractive even if estimated cost savings or opportunities for revenue from the combined company are less than I expect?
Strategic Considerations:
- Branding, distribution, and scale. Does the deal provide the potential combined company with greater economies of scale, increased distribution channels, or stronger branding?
- Organic growth. Does the deal hamper the potential combined company's potential for organic growth?
- Integration. Have we properly accounted for managerial, technological, and cultural integration issues?
- Geographic and product expansion. Is there significant overlap between the potential combined companies' geographic and product markets, and will the deal provide an opportunity for expansion?
Our summary findings for a group of ten deals are presented in the accompanying figure.
Our findings suggest in no uncertain terms that firms should be wary of undertaking M&A megadeals. If shareholders who are reeling from the last several months of performance can take solace in one fact, it is that the ability to do M&As may be hampered, at least in the short to medium term, by the economy and credit conditions.
However, these types of exogenous pressures on M&As will ultimately subside, and when this occurs, investment bankers and a host of others will come running back with suggestions for large M&A deals. They will also come equipped with facts and figures showing extensive strategic benefits and magnificent projections about cost and revenue synergies.
Oftentimes, they will paint a picture of market leadership, industry transformation, a bold new vision for the combined entity, and amazing shareholder returns. When this time comes, CEOs and CFOs must resist many elements of these "compelling" narratives, which we readily admit have a seemingly magnetic pull.
Instead, if -- as stewards of shareholder money -- they take a dispassionate view of the transaction in question, remember the abysmal historical track record of large M&A deals in the past, and also recognize the outsize role that luck plays in successful deals, the decision to say "no deal" should be quite easy.
Research Methodology
For each of the megadeal transactions evaluated (all of which took place between 2002 and 2007), data was collected and analyzed as follows:
- Data was collected from 60 business days prior to announcement until two years after close.
- Most of the analysis was conducted on data from 60 days prior to announcement until 265 days after announcement (slightly over a year) in order to put all of the deals on the same time scale. This was a sufficient time span because on average the deals closed within 121 days and most companies' excess returns displayed discernible patterns by the end of this time period.
- Excess beta return was used as the primary metric for financial success because it measures how much the individual stock's excess return varies in comparison with the market as a whole. The cumulative excess beta return was calculated by zeroing out the returns at the day before announcement (day --1) and then aggregating the returns for each successive day while holding day --1 as the base.
- Each acquirer's returns were also compared to the company's specific sector index, in order to account for macroeconomic factors or market trends that may have affected individual segments.
- Each deal was analyzed on an individual basis using financial data, company reports and presentations, and media reports and news surrounding each deal.
About the Deals Analyzed
- The deals spanned all nine of the S&P 500 sectors.
- The Financials sector was particularly well represented, owing to the fact that several financial institutions were engaging in aggressive geographic and market expansion during the time span covered.
- Deals were categorized as either a "Merger of Equals" or as an "Acquisition." For the purposes of this study, a "Merger of Equals" was defined as a deal in which the market capitalization of the buyer was less than or equal to 1.5 times the market capitalization of the target at 60 days prior to announcement. All others were considered "Acquisitions."
- The majority of the deals were from the United States and Canada simply because of the greater amount of information that was available; however, a few European deals were also included.