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Valuing Acquisitions

The Post-Deal Performance of Merged Companies

Many studies examine the extent to which mergers and acquisitions succeed or fail after the firms combine. Most studies conclude that many mergers fail to deliver on their promises of efficiency and synergy, and even those that do deliver seldom create value for the acquirers’ stockholders.

Evidence that Mergers often fail

McKinsey and Co. examined 58 acquisition programs between 1972 and 1983 for evidence on two questions: (1) Did the return on the amount invested in the acquisitions exceed the cost of capital? (2) Did the acquisitions help the parent companies outperform the competition? They concluded that 28 of the 58 programs failed both tests, and six failed at least one test. In a follow-up study[12] of 115 mergers in the U.K. and the U.S. in the 1990s, McKinsey concluded that 60% of the transactions earned returns on capital less than the cost of capital, and that only 23% earned excess returns.

In 1999, KPMG examined 700 of the most expensive deals between 1996 and 1998 and concluded that only 17% created value for the combined firm, 30% were value neutral and 53% destroyed value[13]. A study[14] looked at the eight largest bank mergers in 1995 and concluded that only two (Chase/Chemical, First Chicago/NBD) subsequently outperformed the bank-stock index. The largest, Wells Fargo’s acquisition of First Interstate, was a significant failure. Sirower (1996) takes a detailed look at the promises and failures of synergy and draws the gloomy conclusion that synergy is often promised but seldom delivered.

The most damaging piece of evidence on the outcome of acquisitions is the large number of acquisitions that are reversed within fairly short time periods. Mitchell and Lehn note that 20.2% of the acquisitions made between 1982 and 1986 were divested by 1988.

Studies that have tracked acquisitions for longer time periods (ten years or more) have found the divestiture rate of acquisitions rises to almost 50%, suggesting that few firms enjoy the promised benefits from acquisitions do not occur. In another study, Kaplan and Weisbach (1992) found that 44% of the mergers they studied were reversed, largely because the acquirer paid too much or because the operations of the two firms did not mesh.

Mergers that Succeed

There are clearly exceptions to this pattern of failure. Some firms, such as GE, Cisco and Browning Ferris, have successfully increased value over time using acquisitions. Even those firms classified as failures in the studies quoted in the previous section can claim that it takes time for acquisitions to work and create value. Some studies find improvements in operating efficiency after mergers, especially hostile ones[15].

Healy, Palepu, and Ruback (1992) found that the median post-acquisition cash flow returns improve for firms involved in mergers, though 25% of merged firms lag industry averages after transactions. Parrino and Harris (1999) examined 197 transactions between 1982 and 1987 and categorized the firms based upon whether the management is replaced (123 firms) at the time of the transaction, and the motive for the transaction. They find that

· On average, in the five years after the transaction, merged firms earned 2.1% more than the industry average.

· Almost all this excess return occurred in cases where the CEO of the target firm is replaced within one year of the merger. These firms earned 3.1% more than the industry average, whereas firms, whereas when the CEO of the target firm continued in place the merged firm did not do better than the industry In addition, a few studies examine whether acquiring related businesses (i.e., synergy-driven acquisitions) provides better returns than acquiring unrelated business (i.e., conglomerate mergers) and come to conflicting conclusions with no consensus.[16] Nail and Megginson examined 260 stock swap transactions and categorized the mergers as either a conglomerate or a ‘same-industry” transactions. They found no evidence of wealth benefits for either stockholders or bondholders in conglomerate transactions. However, they did find significant net gains for both stockholders and bondholders in the case of mergers of related firms. Finally, on the issue of synergy, the KPMG study of the 700 largest deals from 1996 to 1998 concludes the following:

5. Firms that evaluate synergy carefully before an acquisition are 28% more likely to succeed than firms that do not.

6. Cost saving synergies associated with reducing the number of employees are more likely to be accomplished than new product development or R&D synergies. For instance, only a quarter to a third of firms succeeded on the latter, whereas 66% of firms were able to reduce headcount after mergers.

Odds of Success

In summary, the evidence on mergers adding value is murky at best and negative at worst. Considering all the contradictory evidence contained in different studies[17], we conclude that:

· Mergers of equals (firms of equal size) seem to have a lower probability of succeeding than acquisitions of a smaller firm by a much larger firm[18].

· Cost saving mergers, where the cost savings are concrete and immediate, seem to have a better chance of delivering on synergy than mergers based upon growth synergy.

· Acquisition programs that focus on buying small private businesses for consolidations have had more success than acquisition programs that concentrate on acquiring publicly traded firms.

· Hostile acquisitions seem to do better at delivering improved post-acquisition performance than friendly mergers.

Why do mergers fail?

Looking at the evidence, then, a large number of mergers fail. There are a several reasons, but these seem to be the most common:

· Lack of a post-merger plan to deliver on synergy and control: Firms in many mergers seem to believe that the value enhancements associated with synergy and control will arise on their own. In reality, however, firms must plan for and work at creating these benefits. The absence of planning can be attributed to the fact that firms are seldom concrete about what form synergy will take and do not try to quantitatively estimate the cash flows associated with synergy. That is why we believe it is important that firms try to estimate and value synergy, at the time of an acquisition. Though the estimates are likely to be noisy, the process of thinking about synergy and putting projections down on paper is the first step in planning.

· Lack of Accountability: Closely related to the first problem is a lack of accountability after acquisitions are done. A large number of people want to be involved in and lay claim to the credit when acquisitions are announced, far fewer of these individuals want be held responsible for the post-acquisition work of delivering on the promises made at the time of the deal. This criticism applies not only to the managers of the acquiring and target firms, but to their investment bankers as well. The only way to ensure that the high expectations at the time of the deal come to fruition is to hold those pushing most strongly for the deal responsible for delivering on its promises.

· Culture Shock: A firm acquires a culture over time that helps it attract and keep its employees. When firms merge and try to consolidate, their cultures are likely to come into conflict. If not managed right, one or both firms will face employee flight and loss of morale. This problem becomes bigger as firms get larger, and the cultural differences run deeper.

· Failure to consider external constraints: In valuing control, we assumed that firms making poor investments would be able to raise their return on capital and become more productive. This is not always easily accomplished and may require painful decisions about employee layoffs. In an unconstrained free market, these actions can be carried out, albeit with significant emotional and economic pain to those involved. More realistically, firms have to deal with unions and governments that may not take kindly to these actions. In such cases, the firm may be constrained in terms of implementing the actions it had planned to take.

· Managerial Egos: In most mergers, the managers at the top of the combining firms have to co-habit and share power. Although they might do so initially, power struggles often arise between the chief executives of the combining firms. These disagreements ripple down through the organizational ranks, leading to a loss of focus on the original motives for the merger.

· The Market Price Hurdle: Even the best acquisitions will fail stockholders if the acquiring firm pays too much for the target firm. When acquiring a publicly traded firm, the acquirer has to pay the market price plus a premium. To the extent that the market price might already incorporate the value of synergy or control, and the premium is driven up by rival bids for the target firm, it becomes difficult to avoid the winner’s curse[19]. This may explain why acquisitions of private firms, where the premium is not added to a market price, are more likely to succeed than acquisitions of publicly traded firms.

--> CT 26.3: Assume that you have been in put in charge of coming up with an acquisition strategy for your firm. What are some of the actions you would take to make the strategy a success for your stockholders?


12 This study was referenced in an article titled “Merger Mayhem” that appeared in Barrons on April 20, 1998.

13 KPMG measured the success at creating value by comparing the post-deal stock price performance of the combined firm to the performance of the relevant industry segment for a year after the deal was completed.

14 This study was done by Keefe, Bruyette and Woods, an investment bank. It was referenced in an article titled "Merger Mayhem" in Barrons, April 20, 1998.

15A study by Healy, Palepu and Ruback (1989) looked at the post-merger performance of 50 large mergers from 1979 to 1983 and concluded that merged firms improved their operating performance (defined as EBITDA/Sales) relative to their industries.

16 Michel and Shaked (1984) and Duofsky and Varadarajan (1987) find that diversification-driven mergers do better than synergy-driven mergers, in terms of risk-adjusted returns. Varadarajan and Ramanujam (1987) find that the latter do better in terms of return on equity.

17 Some of this evidence is anecdotal and is based upon the study of just a few mergers.

18 This might well reflect the fact that failures of mergers of equal are much more visible than failures of the small firm/large firm combinations.

19 The winner’s curse refers to the likelihood that the winner in an auction is likely to overpay for the item he or she bid on. The same phenomenon would apply in acquisitions where there are multiple bidders for the same target firm.

Prof. Aswath Damodaran

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