Topic 15: Introduction to global mergers and acquisitions Topic 15: Introduction to global mergers and acquisitions Learning outcomes ⦁ understand the behavioural and merger market financial reasons why the ‘urge to merge’ tends to return after the deepest recessions ⦁ comprehend merger valuation lessons from the first post-1980 business-merger wave, and the wave of 1996–2000 ⦁ identify key aspects of the four-phase pattern characteristic of each of the four business-merger waves since 1980, including the present, from both buyers’ and sellers’ perspectives ⦁ understand how increasing acquisition purchase premium levels increases the risk of acquisition failure in later phases of the cycle. Introduction What happens when firms want to merge, but the answer emerging from applying merger evaluative criteria is ‘don’t do the deal’? Justified or not, it was not that long ago that qualitative reasons and/or misleading metrics such as EPS (earnings per share) were used to try to make marginal deals appear more acceptable. The malpractice of using EPS persists when APP–NRS (net realisable synergies) says ‘no’, meaning that the merger is not financially justified. Board members, ignorant of even the basics of modern merger valuation, are inclined to follow the guidance of their chief executive officer (CEO). It’s important to mention at this point that ‘mergers’ usually refers to mergers of equals, where two companies of similar sizes put their businesses together to achieve economies of scale or strategic targets such as an international expansion or an improvement in product quality. Usually a new company is created where the assets and liabilities of both companies are combined proportionately and the management function is integrated, taking into consideration both companies’ objectives. By contrast, an acquisition usually involves a larger company acquiring a smaller company, involving dissolution or reduction of the target company’s board of directors and/or management team and the implementation of the purchaser’s strategy and processes. We mention this now, because most financial newspapers today misuse the term M&A for all types of deals, not differentiating what type of deal it really is. Most deals today are acquisitions. This topic will look at similarities and differences between the present merger wave and preceding cycles, and why this is important. While all merger cycles exhibit similar characteristics, the differences between one wave and the next are often key to successfully navigating mergers and acquisitions. Beginning the journey We're at an early point in the process of exploring merger dynamics and the systematic pursuit of successful deals – along with avoidance of those mergers more likely to move towards destruction of value. Merger valuation (referred to in Clark’s chapter as ‘MergVal’) refers to the systematic, objective assessment of individual transaction’s success or failure, on an independent basis. Although many people claim to be able to gauge M&A success accurately, conflicts of interest may distort such proclamations, especially because deal intermediaries tend to view merger ‘success’ as synonymous with closed transaction volume alone. This is a logical stance in an environment where advisors are almost never held accountable for substandard merger advisory, despite the reality (proven over decades) that more than two-thirds of all mergers fail. The saying ‘what goes up must come down’ also applies to mergers, which tend to move in ‘waves’ that follow the now-familiar pattern of the economic cycle: at first, halting slow rebound from the recent recession’s financial depths, then eventually progressing towards modest growth. But all good things and all bubbles must eventually come to an end, and the seeds of the merger wave’s self-destruction are planted years before the collapse. Late-to-market acquirers try to emulate the success of those few acquirers who were early to recognise the existence of a new M&A wave and acted promptly on it. But conditions change within the average M&A wave’s four to eight-year duration. A toxic combination of higher selling prices and deterioration (in terms of fewer targets being available that have the ideal mix of manageable size and readily-extractable synergies[29]) means that viable deals dry up, but some companies and their bankers and advisors continue trying to realise material gains from M&A deals nonetheless. During the early-to-mid phases of the merger wave, it may even appear to some that a few select M&A transactions ‘pay for themselves’, as increases in the buyers’ share prices temporarily exceed the premiums above pre-bid share prices, which buyers must to pay to gain control of the firm they want to acquire. The phrase for this extra amount over the pre-bid share price of the target company is acquisition purchase premium, or APP. (While APP may be expressed in either financial or percentage terms, the latter provides some special insight into the phase of the M&A wave, including opportunities and constraints corresponding to that point in the cycle and even some hints about how long it will be until the present merger boom loses its footing.) But things soon go back to normal: the customary situation is that the buyer’s share price goes down and the seller’s goes up roughly by the amount of the premium. At this point, acquirers’ something-for-nothing M&A illusion melts away. If you think that this description of the cyclical patterns of merger waves resembles the patterns of many stock (share) markets, commodity markets and Initial Public Offering (IPO) markets, that’s not just a coincidence. Merger market volume tends to follow stock markets and lead IPOs. Initially, increased share prices are increasingly used as merger transaction currency by acquirers (the higher overall prices in the stock markets, the higher the bidding price will be). Later, enthusiasm for buying up shares of established, already-public firms spills over into new demand for upstart firms which are not yet public (but become so through IPO processes). But M&A transaction volume tends to lag long behind the beginning of each merger cycle, resulting in many M&A deals being closed in the second half of the economy cycle. In the present merger wave, this gap has been particularly pronounced. The beginning of the present period of conditions conducive to successful (for acquirers) mergers began slightly more than two years before ‘Merger Monday’ on 13 January 2014. That was the multiple-transaction merger explosion date, after which even the most unconvinced M&A boom cynic could no longer have any doubts that this acquisition resurgence had arrived (and that they were late to the party). The eye can sometimes play tricks on the mind, and excessive caution may initially deter investors from buying shares of a stock early when it is modestly priced, just to make extra sure: ‘I think I’ll wait to see if the price keeps rising before buying, just in case this is a fluke’. The offsetting extreme at the end of cycles is pandemonium by contrast: an unstoppable plunge in prices. This means that when companies wait too long because they are expecting the target company to increase its market price (the price of the trading shares), they may not be able to acquire it at all if prices start plunging due to the initial phase of an economic recession. Buying all the shares of the company (as in acquisition) becomes just another manifestation of this stock market emotional and financial roller-coaster ride. Conclusion Markets are driven by people and people are driven by emotions. When the management team in place at a firm observes how other CEOs and CFOs try to reach higher levels of growth by moving towards M&A deals, and when market conditions favour the acquisition of other companies, they often follow suit. It is difficult to stop the wave that leads to these types of deals, even if they don’t make perfect financial sense – in other words, even if the purchase price is extremely high compared to the target company’s value. Before this topic, if you were evaluating a deal, what told you it was going to be a success? Thanks to the sometimes energetic attempts of financial public relations firms, M&A deals often look rosy, making evaluation difficult. Or did you look at prices paid with increased scrutiny when a sector seemed to be grossly over demanded merger-wise? The materials and activities in this topic may help inform your decision to perhaps re-address some of the insights already provided here, in order to update your understanding. Essential reading Bishop, M. ‘Riding the wave; Schumpeter’, The Economist 409(8856) 2013, p.71. Watts, W. ‘Record pace of M&A may be too hot for market’s own good’, MarketWatch (December 4, 2015). Remember that all the essential reading for this programme is provided for you. Click the link (which may take you to the Online Library where you can search for a journal article) or click ‘next’ to go to the next page and start reading. Essential reading 2 Clark, P. ‘Chapter 1: Dynamics of the merger megaboom/dot-com 2’, adapted from Clark, P. and R.W. Mills Masterminding the deal: breakthroughs in M&A strategy and analysis (London: Kogan Page, 2013) © Pondbridge Ltd 2013. All rights reserved. The right of Peter J Clark and Roger W Mills to be identified as the authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Reproduced by permission of Kogan Page Ltd. Remember that all the essential reading for this programme is provided for you. Click the link (which may take you to the Online Library where you can search for a journal article) or click ‘next’ to go to the next page and start reading. 15.1 Clark Chapter 1: Dynamics of the merger megaboom/dot-com2 Author’s note: The majority of the chapter excerpts included here were developed over two years prior to ‘Merger Monday’ (MM: 13 January 2014’s multiple mega-transaction watershed date). MM was immediately recognised across the financial community as the date after which the existence of a major merger boom could no longer be doubted.[30] M&A cycles "tend to last five to seven years, and we are two years into it." Boutique investment bank Evercore Partners’ CEO, Roger Altman, on May 6, 2011, six months prior to this author’s estimation of the actual beginning of the present business-merger wave.[31] The phrase ‘Most Mergers Fail’ is today widely cited in business, academia and media, reflecting a broad (and today, verified and substantiated )[32]perception that approximately two-thirds of all mergers are perceived as ‘failing’ based on the criteria available at the time.[33] While such opportunistic hucksterism from deal facilitators hoping to stick their snouts into the rich merger fee trough is as predictable in each M&A cycle as rain is in England, the bromide nonetheless has a ring of truth. Most mergers still fail[34], based today on the most widely applied merger practitioner financial criteria, returns to the acquiring company’s shareholders[35]. While acceptance that two-thirds or of all mergers ‘fail’ has been almost universally accepted since the mid 1990s, the two-third guideline begs related questions: So what does ‘merger failure’ mean, and to whom? The acquiring company’s shareholders they ultimately put up the risk capital for a deal and are first to benefit or suffer from management’s M&A proficiency (or in an alarming number of instances, lack of same). Stated another way, while a banker or other deal intermediary – both of whom goes unpaid unless the deal in question is closed – are inclined to label a deal that isn’t consummated as ‘failure’ (understandable, considering possible implications about future job security), such self-serving perceptions steers are distraction. 15.1.1 Business-Merger Waves: Patterns, theories on causes, issues Merger-related activity has periodically surged since the late 19th century. In cyclical manner, boom years are invariably followed by several years of correction and contraction. As both reflect optimism about future commercial prospects, the fact M&A transaction patterns closely parallel bull market periods in the overall economy (as suggested by Figure 1.1 US merger patterns 1926–2004: percentage of companies taken over, quarterly basisSource: Based on some data cited in Martynova and Renneboog, 2008, Figure 1, 2150, plus other cycle trend sources. Statistics to 1954 are attributed to Nelson (1959), 1955–1962 to Historical Statistics of the US-Colonial Times to 1970, 1963–1997 to Mergerstat Review. Post-1997 statistics are attributed to The Value Creators Report) is no surprise. Past merger bubbles display patterns of alternating growth followed by retrenchment. Martynova and Renneboog affirm that “it is a well-known fact that mergers and acquisitions (M&A) come in waves.” (2008, 2148) [36] Figure 1.1 US merger patterns 1926–2004: percentage of companies taken over, quarterly basis Source: Based on some data cited in Martynova and Renneboog, 2008, Figure 1, 2150, plus other cycle trend sources. Statistics to 1954 are attributed to Nelson (1959), 1955–1962 to Historical Statistics of the US-Colonial Times to 1970, 1963–1997 to Mergerstat Review. Post-1997 statistics are attributed to The Value Creators Report The beginning of each new business-merger cycle signals that optimism is back, despite the consistency of miserable (that is, value-destructive to the acquiring firm) M&A performance. This Time is Different, as the name of Reinhart & Rogoff’s 2009 book proclaims, tongue-in-cheek. Despite the Depression’s major influence on 20th century American and Western economic thinking since then, Figure 1.1 US merger patterns 1926–2004: percentage of companies taken over, quarterly basisSource: Based on some data cited in Martynova and Renneboog, 2008, Figure 1, 2150, plus other cycle trend sources. Statistics to 1954 are attributed to Nelson (1959), 1955–1962 to Historical Statistics of the US-Colonial Times to 1970, 1963–1997 to Mergerstat Review. Post-1997 statistics are attributed to The Value Creators Report suggests that the Roaring Twenties were conspicuous by its modest M&A volume. Immediately before the Great Depression, quarterly takeover volume never reached even one percent of all publicly traded US companies. But that low threshold was easily exceeded by the M&A surge of the late 1960s–early 1970s, and later by each of the four ‘Volcker Era’ Post-1980 business-merger booms commented upon elsewhere in this chapter. Fast forward to the growth stock era of the Mid 1960s and conglomerate mania that bubbled up a couple of years later. ‘Multi-companies’ (aka conglomerates) were touted in the early 1970s as financial value magic. Two elements of the then-prevailing conglomerate fiction were: (1), a holding companies with diverse investments in different sectors was better positioned than a single core business company to withstand downturns affecting any one industry; and (2), a diverse business unit portfolio could help facilitate value-maximizing Cash Flow transfers from cows (cash generators) into stars (cash-hungry but high value separate business units or SBUs)[37]. Today’s closest equivalent in the West, so-called roll-ups, focus on single industries instead of a diverse business unit operating portfolio. Nonetheless, persistence in the conviction that serial mergers per se create value lies mostly in the eye of the M&A programme’s champion. Although 67% of deals flop, mergers do create value- but for fee-earning deal intermediaries, rather than principals. A New Merger Era: The post-1980 business-merger waves A convincing argument may be made that both the general business environment and merger conditions significantly changed in 1980-1982, thus supporting a contention that the four M&A ‘waves’ of the Volcker Era merit separate attention (Table 1.1 The four merger cycles of the post-1980 Volker low-inflation eraSource: © Pondbridge Ltd. 2015-2016, all rights reserved). Table 1.1 The four merger cycles of the post-1980 Volker low-inflation era Source: © Pondbridge Ltd. 2015-2016, all rights reserved While attempts at imposing Friedman-style monetary discipline were at best inconsistent following the 1980 watershed election year in the US, Paul Volcker’s Federal Reserve is deservedly credited today with breaking the back of inflation. That, in turn, spawned new underlying conditions which would establish conditions conducive to the four biggest merger booms in history, all of which occurred after 1982, as ⦁ Corporate CEOs no longer were required to be obsessed about advance purchasing of inventories to beat ever-increasing prices, thus freeing up capital for other uses such as strategic alliances & mergers (external investment); ⦁ A return of confidence in the benefits of capitalism (following disheartening proclamations of ‘malaise’ during the preceding Carter administration) translated into new willingness by businessmen to pursue returns involving moderate risks; ⦁ New-found price stability encouraged both providers and customers to invest in capex (internal investment), the foundation of any enduring productivity improvement critical to sustaining the recovery. [⦁ 38] As the Merger Wave Progresses… Each affirmed merger cycle represents a semi-closed market, subject to supply and demand swings. Once firmly established, merger mania spins its own reality. Early on, something-for-(nearly)-nothing easy gains appear available to many to be available for the taking by any and all market participants. From the beginning of March 2013 until about May 2014, excepting those deals that were deemed to be (a) dead on arrival because of excessive price relative to achievable synergies (the No. 1 reason overall for merger failure, after all) or (b) dissimilar businesses between acquirer and acquire, merely announcing a new merger likely cause the the buyer’s share price to soar. The latter (b) is dissimilar to customary rational market conditions. On an event studies (ES) basis – the leading scholarly basis for evaluating merger impact but under increasing attack by merger practitioners since the late 1900s[39] – share prices of sellers typically increase when a deal is announced, but with a corresponding, near-equivalent decline in buyers’ share prices. The amount of that upwards swing up in the selling firm’s share price – along with the corresponding decrease in the buyer’s share price – is primarily influenced by the true Acquisition Purchase Premium associated with that specific merger transaction. By definition, APP represents deliberate overpayment in excess of the target firm’s market value which an acquirer must pay in order to secure control. Those halcyon days when merely announcing a merger causes the buyer’s share price to rise (assuming related businesses and defensible price) prove to be short-lived. Something-for-nothing rarely lasts for long, after all. That period of orderly merger activity (from 3/13 until 12/13 in the present merger wave) is eventually displaced by M&A feeding frenzy. To most, Merger Monday (Jan. 13, 2014) market that date when merger laggards rushed in to buy in this cycle, as executives on both sides of the Atlantic suddenly, simultaneously realised that had already missed the first two years of the present merger boom. Prices of potential target companies dramatically rise as: ⦁ Anticipatory acquisition premium factors into target companies’ rising prices, in expectation of possible future bid interest by buyers. And by the date the M&A bubble reaches the mid-cycle feeding frenzy point, almost any company is a possible acquisition target. (See the Chart of the Day on Sam Ro’s article on ⦁ Business Insider UK.) ⦁ Premia-APPs – also rise, thus exerting double upward pressure on prices of target firms’ shares, if acquired. ⦁ However, the other part of today’s prevailing merger valuation methodology – synergies – do not keep pace. On a specific acquirer-acquiree basis, synergies to be flat throughout the merger cycle, as graphically depicted in ⦁ Figure 1.4 Considering both value gap determining factors, over the business-merger cycle Source: © ⦁ Pondbridge⦁ Ltd. 2012-2013 all rights reserved⦁ [⦁ 40]. The practical consequence that merger success probabilities dramatically plunge. The reason: improvement in company operating cash flows (CFs) – the actual driving force behind all corporate value improvement – almost never keeps pace with the short-term merger boom price spike, with the result that targets’ share prices times APP that increasingly appear to be out of synch with companies’ operating performance realities. [41] The fleeting mirage of merger easy money disappears as fast as it arrived. The number of appealing targets is depleted as a consequence of the now-excessive urge to merge. Merger target quality – and thus, M&A transaction viability – recedes. Instances of gross overpayment and the accompanying[42]higher merger failure probability (deals with APPs above 38%, according to two major academic studies[43]) multiply. In reaction, some acquirers lower their standards pursue companies in low probability but oh-so-stylish ‘new concept’ areas. Some other buyers go the opposite direction, seeking oversized targets. Both errors reduce merger success percentages further.[44] Laggards two+ years late to the present merger wave – that is, those who delayed to act until after Merger Monday (MM) in mid Jan. 2014 – risk making a fundamental M&A cycle timing error if they erroneously presume that the cycle started at MM. Given the minimum duration of M&A booms of the Post 1980 era (4 years duration, Wave 2, Dot-Com I, 1996-2000), that MM start point mistake leads to second, related error: the expectation that the present merger wave might endure until 2018. Such mangled reasoning is reminiscent of the reveler who arrives to a party at 11 pm which started at 8 pm, yet insists that nothing at all happened prior to his arrival. Those two years late to this merger cycle missed out on two years of ‘sweet spot’ favourable merger market conditions (many targets, reasonable prices & APPs) plus the easy ‘win’ acquisition period starting March 2013 and possibly earlier.[45] Hubris combined with a desire not to be labeled as someone who missed a substantial part of what is now recognised as the world’s biggest merger boom explains the desire to re-write history. Arguably, one of the worst sins in Canary Wharf and Wall Street is to miss a market boom. At this writing in Dec. 2015, focus is instead directed to the present merger cycle’s end-point. Precedent suggests that period of time from merger market peak until M&A Endgame is two years at the longest. Chances are high that both the stock market (US’s Standard & Poor’s 500 Index, SPX) and US-EU merger markets both saw their peaks in 2015. Economist Espresso of Dec. 29, 2015, “Bid ‘Em Up: M&A in 2016” proclaimed that: Traditional warning signs are (now) flashing red. The multiple of gross operating profit being paid now is 11.3 times, close to the peaks of 1998-99 and 2007. So why continue to chase low probability mergers with Merger Endgame clouds now threatening?[46] ⦁ CEO Hubris: Informed that deal success probability is only 33% (inverse of the two-thirds failure level) or less, the laggard CEO now pressured by this Board to quickly act imagines himself as that rare super-manager capable of beating those long odds of M&A success. Chest-thumping and spin by ‘guiding’ advisors ravenous for one last, big payday pours petrol on this fire of excessive acquiring company CEO confidence.[47] ⦁ Possible Exclusion from the industry’s New Order: To many, the possibility of being excluded from the sector’s New Order now being forged by multiple acquisitions initiated by others renders today’s prevailing synergy versus premium merger decision-making criteria moot. The embattled MD’s expedient logic: first do a big deal that guarantees our company a place at the industry’s top table; price is a secondary consideration. Then and only then ponder the nuances of value-creating versus value-destructive acquisitions and the criteria that distinguishes those two groups. A further possible motivation is the (still) high prices of the wannabe acquiring company’s stock price. Until a significant correction takes the air out of the stock market bubble – and that usually doesn’t happen until near the cycle’s end (remember the Chart of the Day on Sam Ro’s article on Business Insider UK) – top management may reason that they still possess valuable acquisition currency in the form of the wannabe buying company’s own shares. And if they are even slightly concerned about the aforementioned 29.12.15 Economist warning or Watt’s earlier (4.12.15) MarketWatch piece citing me entitled “Why some market watchers think the M&A party is almost over.” (FN 20), then there’s additional incentive to utilise that currency as soon as possible in a deal. Before the buying power of that ‘currency’ falls. Which leads us to Gresham’s Law, aka the use of acquirer’s inflated shares as acquisition currency. During a general economic resurgence almost always accompanied by (if not preceded by) a stock market bull market, a marked increase in the publicly traded companies’ share prices occurs. This coincides with improved investor sentiment and is mirrored by surging share prices in the market overall. The effect (‘a rising tide lifts all ships’) sometimes encourages a misperception that value has been created in the prospective acquiring company, without effort. Right? ⦁ Not necessarily. The rising tide effect might partially reflect an increase in underlying worth, but only if that firm’s cash flows (CFs) from operations also improve, as noted earlier in this chapter (FN 14). CFs drive company share price, not the other way around, as attested in multiple scholarly research studies. ⦁ If and when share prices outpace CF, bubble faux-valuations arise, giving rise to the one instance when the stock pundits’ oft-cited pet phrase ‘overvalued’ is actually correctly used. But as with any bull market, once the boom is confirmed, late arrivers’ hope for gains and dealmakers’ lust for fees overwhelms. If the shares might be used to buy something with a fixed price, the number of shares required shrinks, thus fostering another something-for nothing illusion. If shares are used as acquisition currency in a merger deal, some in the company might imagine that the ‘savings’ means the company has spare funds to spend on other things. An (apparent) bargain![48] Gresham’s Law is sometimes explained by the phrase bad money forces out good. Mis-perceiving the bubble price of the company’s shares as an asset which is lost if not used, management may be inclined to be less careful about target suitability. AOL’s disastrous acquisition of TimeWarner on Jan. 10, 2000 is one example as AOL’s share ‘currency’ was highly valued by the target’s chief executive, Gerald Levin. That misdiagnosis rendered that illogical and massively value-destructive deal thinkable at the time.[49] Dot-Com 1 bubble popped a month after that deal was closed. Patterns: Four Recurring Phases of the M&A Wave Several factors contribute to the persistence – and sometimes, the acceleration – of merger mania despite the fact that peaking P/Es and APPs strongly argue that CEOs should instead stand aside. ‘Winning by walking away’ (from the dead-on-arrival deal) is not in the headstrong CEOs lexicon. Given (a) their insulation from the consequences of bad merger advice plus (b) their self-interest in extracting some more final phase fees, advisors and dealmakers are especially supportive of the spin that late-in-cycle deals may be just as safe as transactions earlier in the cycle. One just have to be slightly more selective (and we’re just the guys to help you out in that regard!). The four-phase reality of merger cycles is 25 years old as Figure 1.2 A pattern of merger wave expansion and collapse key events: post-1980 merger wave 1: 1982–90 (LBO) Source: © Pondbridge Ltd. 2012-2013 all rights reserved shows, tracing back to a key graphic from my 1991 book (this particular graphic dates back to Spring, 1989). Figure 1.2 A pattern of merger wave expansion and collapse key events: post-1980 merger wave 1: 1982–90 (LBO) Source: © Pondbridge Ltd. 2012-2013 all rights reserved The point in time late in the wave when solid lines change to dashed lines reflects the mystery as of 5/89 about the future of late stage deals. Turns out that 8c, the lowest trajectory shown in the exhibit, actually occurred, a pattern since duplicated in waves since. Figure 1.3 Identifiable merger phase and acquisition purchase premium (APP) percentage ranges Source: © Pondbridge Ltd. 2012-2013 all rights reserved [50]further helps to illuminates the causes of late cycle merger collapse. Figure 1.3 Identifiable merger phase and acquisition purchase premium (APP) percentage ranges Source: © Pondbridge Ltd. 2012-2013 all rights reserved The last merger wave crashed. Three years later, and next wave is just around the corner (but this time we’ll do it right!) The Roman numerals in Figure 1.3 Identifiable merger phase and acquisition purchase premium (APP) percentage ranges Source: © Pondbridge Ltd. 2012-2013 all rights reserved correspond to four identifiable phases characterizing each of the Post-1980 merger waves. Since both components of the offer price – pre-announcement share price of the target company and the APP percentage premium required to secure control of that firm – tend to rise as the merger wave ages, deals closed earlier in the cycle face a higher chance of success. Timing is arguably the most important merger success consideration outside of overbidding per se, especially as it impacts on several other factors affecting M&A success: not just price, but also indirectly synergies and implementation speed and effectiveness. As Akdogu et al. suggest, “There is ample reason to believe that the… (specific merger’s) tendency to create or destroy value may differ depending on… whether it is early or late in the wave.” [51] Riding the Merger Wave’s Four Phases[52] Phase I: Green shoots are coming up – or are those weeds? Emerging from a prolonged recession, optimism gradually returns. Initially, biz media acts as if the recession never ended, sometimes even when Leading Economic Indicator (LEI) or the important LEI/CEI indicators argue otherwise.[53] Fear about a double dip return to recession dominates the pop-biz media idle chatter for a while, but each passing month silences more and more of the doom-mongers. But even if those fears were legitimate (they aren’t), effect is minimal: Look at the last three Post-1980 merger waves when quarterly GDP either did decline temporarily (Wave 1, LBO, 1982-1990), or came close, (prior to Wave II Dot Com I, 1996-2000).[54] The nascent M&A wave is hardly effected at all; at most, start date of a robust new merger period is delayed by a few quarters. At this point in the business-merger cycle, cyclical targets are trading at the low end of their 7-8 year price-earnings (P/E) multiple ranges. On an opportunistic basis, a few maverick all-cash buyers decide to act despite the adverse merger market sentiment. Some cheap targets become newly available as their owners lose patience during Phase I. But except for occasional bottom-trawler deals initiated by bargain hunters, merger activity remains suppressed.[55] Phase II: Jump-starting the new business-merger expansion period Something new is required in order to steer financial community’s attention away from the last recession and what preceded that. The preceding business-merger wave is by this point in time viewed by most as symbolic of waste, greed and value destruction. We thought it would all be different that time… how could we be so completely fooled… Again? Even though attractive targets at reasonable prices appear to be plentiful, the knee-jerk reaction at this point in time tends to be unyielding. M&A opponents cherry-pick adverse news from the biz-media to argue their point, Why even bother because of the risk still in the market? Some company and country sovereign debt defaults are still occurring. But time cures all – even the ‘disease of merger mis-diagnosis early in the wave – and as the second phase progresses, the number of such threats to the nascent merger wave are perceived as fading. Phase III: So how come you missed out on the market’s major upward move? By the time the merger wave’s third phase begins, everyone is either close to or has already arrived at the same realisation: It is now safe to pursue deals again. The merger boom is legitimised in different ways, ranging from deal success stories in the financial press to macho proclamations of corporate war chests as merger-expansion oriented chief executives signal their readiness for M&A battle. Then there are the consultants and advisors’ aggressive entry, as if overstatement makes up for missing the merger cycle in its formative (and cheaper) stages. A recurring sakes pitch slightly disguised as analysis: lessons have been learned from the past failures, and that they’re keen to impart their new knowledge with principals (for a fee, of course)[56]. Remember that board member who earlier in the wave criticised your proposal for a major deal at a purchase premium of twenty-two percent more than the target’s price as of the originally proposed announcement date? Today that same director badgers you about why you aren’t pursuing that same target company, even though the price (and APP) are now materially higher, endangering that deal’s viability based on prevailing synergy (NRS) versus premium (APP) criteria. The dilemma is depicted in Figure 1.4 Considering both value gap determining factors, over the business-merger cycle Source: © Pondbridge Ltd. 2012-2013 all rights reserved . While target company prices and APPs both rises relentlessly, synergies for every specific acquirer-acquiree proposed combination changes little over the duration of the wave is at all. The result is a limited window of opportunity for a successful deal. Figure 1.4 Considering both value gap determining factors, over the business-merger cycle Source: © Pondbridge Ltd. 2012-2013 all rights reserved Reminiscent of merger bubbles past, M&A targeting and bid pricing discipline begins to give way to the imperative to complete a major deal: certainly by the middlemen. The essential skillset is to try to convince potential acquirers that even with this late start, viable deals are still out there, waiting to be grabbed. This banker’s enemy: increasing awareness by principals of the realities of merger cycles and M&A transaction success. Miss the sweet spot – the phase in the merger wave when deal success exceeds 50%? A compelling argument (rarely followed) is to sit aside and miss the loss (aka, Winning by Walking Away). The chase for the hotly pursued target assumes a life of its own, outshining less dramatic developments such as ensuring such as analyzing prudent limits on APPs based on precedent and careful examination of realizable synergies, which often differ from the levels that the bidding team is necessary in order to prevail as the selected pursuer willing to overpay for the acquisition by the most. Middle of (Final) Phase IV: Feeling tentatively for the edge of the cliff Attempting to snap a panoramic picture from the top of steep precipice can be a terrifying proposition, whether you suffer from vertigo or not. Inch a bit closer to the edge, and much more of the horizon becomes visible. But how close to the edge of the cliff (to the ending months of the merger wave) do you dare go for fear of falling off the cliff (of experiencing merger failure)? Such is the high-risk nature of aggressive merger activity during the wave’s concluding phase, the fourth. Slick perceptions-bending propaganda featuring spin-phrases such as ‘soft landing’ or ‘managed retreat’ might persuade a few to remain active in the merger game until the bitter end. Direct compelling sales propaganda to a few laggards which regret that they have missed the market’s big move to date, and there might even be some late participants available to scoop up the share positions that earlier buyers abandon, fearing that the edge of the cliff is near. Observing years of active merger activity at defendable purchase premiums, the laggard reasons that the timing is finally perfect to proceed. It isn’t. Excessive delay means that the major merger opportunities in this wave are in the past, that late movers have been whipsawed. Consistent with Figure 1.2 A pattern of merger wave expansion and collapse key events: post-1980 merger wave 1: 1982–90 (LBO) Source: © Pondbridge Ltd. 2012-2013 all rights reserved , Phase IV has a well-deserved reputation as the most treacherous of the four merger wave periods. APPs rise to triple digit percentage levels, rendering the task of first discovering and then securing sufficient synergies to offset those premiums nearly impossible. Some deal financing remains available at least for a while, enabling some of the companies which bought earlier in the wave to bail out of their earlier investment. The purchasers? The late-to-the-boom laggards, eager to make up for lost time. Sheep led to slaughter. More on the Four Post-1980 Four Business-Merger Waves Prior to the present cycle beginning Dec. 2011, there have been three distinct business expansion-merger waves: (1) 1982-1990 LBOs, (2) 1996-2000 Dot-Com I/Friendlies, and (3), the 2002-2008 Subprime Derivatives/Financial Securitization bubble. Each of those waves are comprised of four phases which are typically not fully understood except in retrospect. After the follow-on recession and blame seeking for the value destruction and losses of the last business merger cycle, especially from around the mid-point in Phase III to Merger Endgame. Characteristics of each merger wave phase are described earlier in this chapter. What may be less apparent at this point is how a feature or failure from an earlier merger wave may affect future cycles. Cross-influences between the four post-1980 merger wavesSource: © Pondbridge Ltd. 2012-2013, all rights reserved compares some characteristics of the four Post-1980 merger waves, including the preset one as of this writing. Time period, duration (in terms of elapsed years, actual or expected), and causes of particularly visible value destruction are identified for each of the four Post-1980 cycles. Arrows (bold) depict the adjustments in the next business-merger wave, as the financial community acts to correct the preceding wave’s chronic shortcoming. Cross-influences between the four post-1980 merger waves Source: © Pondbridge Ltd. 2012-2013, all rights reserved Post-1980 Merger Wave 1: Leveraged Buyouts (LBOs), 1982-1990 The first of the four Post-1980 business-merger waves was exemplified by Gordon Gekko in Wall Street and dramatic takeovers, particularly in the US. As noted, a combination of supportive regulatory and financial conditions set the stage for a resurrection of the merger marketplace in that decade. High Leverage Transactions (HLTs) represented a reaction to the value-depressing combination of under-leverage and under-management. For the first half of that cycle-later-turning-to-bubble at least, some acquirers might imagine that financial restructuring combined with commonsense reductions in superfluous discretionary spending might cause the merger equivalent of something for nothing. The target company might be mostly or sometimes completely purchased using its own underutilized balance sheet. Low debt is increased to market levels and the excess not used for expansion indirectly applies to buy the target itself. Post-Wave 1 studies in the1990s criticised hostile takeovers as contributing to some of worst abuses that period including late phase deals with such high APPs that some deals teetered on the edge of collapse at close (including RJR Nabisco, MCC (Maxwell Communications Company) and various media properties). Thus the reaction of what had to happen in the next merger wave was predictable, if naïve. If it could be presumed that hostile transactions played a large role in the 1980s merger excess, next time make sure that that the deal is perceived by target company management as friendly (read: at such a high bid price that opposition disappears). Does that prevent the basic problem (and No. 1 reason for merger failure) of gross overpayment relative to realizable synergies? About as well as throwing petrol on a raging fire as a strategy to put the flame out. Post-1980 Merger Wave 2: Dot Com I (Plus Friendlies), 1996-2000 Post-1980 Wave 2 began in 1996, based on volume considerations and emergence of the commercial Net in 1995-1996 (Netscape’s signature IPO happened in August 1995). On that basis, Wave 2 was the briefest of the four Post-1980 business-merger expansion periods, at four years (five if counted from the time of the Netscape public offering). Note the 180 degree change in order to emphasis friendly transactions as contrasted with noteworthy battles of LBO Wave 1, such as for RJR Nabisco. Schwert (2000) expressed what many other were sensing, then and now: that the so-called hostile-friendly difference in deal types was often irrelevant, as every transaction in which the seller was taking responsible actions to maximise its shareholders’ wealth almost always started with level of initial antagonism from top management at the target firm.[57] Profitless Dot-Coms coming to market presented a separate, significant problem in Wave 2.[58] IPOs usually help spur merger activity in the first half of the new wave as smaller firms become absorbed in consolidation-type mergers (emergent sub-type), while some firm outside of the golden segment seek to buy their way into the new Can’t Miss sector via merger. Both developments roared during the first half of Wave 2, the first Dot Com bubble, but then suddenly collapsed as suspicions rose that some of the acquired companies were not worth the cocktail napkins upon which their thrilling but profitless business model ideas were written. Post-1980 Merger Wave 3: Subprime / Securitized Financial Derivatives, 2002-2008 The third of the four Post-1980 waves was dominated by the debatable concept of universal banking combined with repeal of the Glass-Steagall Act of 1934, since regretted by its driving force, Weill.[59] In retrospect however, the key causal feature underlying Wave 3 was Li’s experimental coppula, suitably referred to in Salmon’s insightful March 17, 2009 Wired article, “Recipe for Disaster: The Formula That Ruined Wall Street.” For those market players unwilling and/or unable to understand the complex equations underlying the use of multiple tranches (or groups) of subprime mortgages and related derivatives, Li’s Coppula was incendiary, particularly when it was mis-perceived and misapplied as somehow justifying mortgage loans to deadbeats. Thus Countrywide Financial, the king of subprime mortgage loans originations appears to be a profit juggernaut in the mid ‘00s – a perception soon revised and then reversed three years later. Barclays ducked a value-destruction bullet by failing to ‘win’ the acquisition bidding war for ABN Amro. Deals in the concluding phase of the 2002-2008 wave were shotgun marriages aimed at saving the world financial markets. JPMorgan Chase absorbed Bear Stearns, Merrill Lynch collapsed into Bank of America while new bulge bracket player Barclays selectively acquired some parts of collapsed Lehman Bros. Wave 4: led by high tech Early extreme excesses of NetPhase I is just part of the stage-setting for what is to come: NetPhase II, when the Dot Coms grow up, when the major new corporations of the 21st century begin to be built, and when the new Internet champions soar. Page xvi in my Net Value: Valuing Dot-Com Companies-Uncovering the reality behind the hype (2000). The present business-merger wave began around in late 2011: several months after consecutive increases in Leading Indicators (LEI) and after the credit bureau’s lagging downgrading of US sovereign debt. Also after the customary 2-3 false start indicators by eager beavers such as Evercore’s Altman (see this chapter’s beginning) chomping at the bit to declare even a modest upsurge as a runaway M&A boom. Not coincidentally, that was about the same time that the first $100Bn Pre-IPO vapor valuation price guess for Facebook was articulated (FB came public in May 2012 at an indicated value for the firm as a whole of $104B). A key feature of the Merger Megaboom will be the introduction of a new type of (mostly) profitable businesses that begin their lives as public companies with the question not being the Dot Com I concern Will those companies survive? but rather, How will those firms handle their explosive success? A new paradigm business model is important in merger waves to beginning to convince M&A doubter-laggards that soon – very soon – it will be safe to do mergers again. Tech dominates now, and yet of the four distinctly identifiable business-merger waves of the Volcker era, only half the breakthrough new-new models[60] are tech-specific: ⦁ Wave 1 (1982-1990): Leverage buy-outs as novel acquisition technique, junk bonds I ⦁ Wave 2 (1996-2000): General commercial internet (Dot-Com I) ⦁ Wave 3 (2002-2007/8): Subprime / Universal Banking ⦁ Wave 4 (12/11 – Q4 2016–Q2 2017): Social networking Net subset (Dot-Com II) Apparently, the deeper the recession, the slower the general acquiring market is to realizing that the merger boom is ON. After 2-3 false starts in 2010 and 2011, it is slightly understandable that leading business media, Big Four accountants and observers were eager to dismiss any prospect of merger resurgence for years later[61]. What is less tolerable is that missing the legitimate signals of the new cycle’s arrival (Figure 1.5 Originally-conceived ‘Perfect Storm’ conditions foretelling an imminent merger boom (end date since truncated to Q4 2016-Q2 2017)Source: © Pondbridge Ltd. 2013 all rights reserved ) after LEIs had swung to positive meant that scores of corporate acquirers following the ‘experts’ missed nearly all of this wave’s ‘sweet spot’, so designated as it represents the combination of reasonable target price plus ample availability. Figure 1.5 Originally-conceived ‘Perfect Storm’ conditions foretelling an imminent merger boom (end date since truncated to Q4 2016-Q2 2017) Source: © Pondbridge Ltd. 2013 all rights reserved By the first quarter of 2012, all six of these ‘Perfect Storm’ conditions were either in place or on the way. Companies suddenly were flush with cash, having cut out unnecessary costs and facing little resistance to long-overdue price increases. High APPs from the bad megadeals of 2007-2008 were by then just fading regrets. Rising share prices had companies considering how those increases might be used as acquisition currency. But a world flush with QE cash plus artificially suppressed interest rates meant that most deals could be financed with cash with few questions asked. Companies like LinkedIn and Facebook appeared to many to be the next major Net firms. The undoing of the wave has to do with the six conditions being reversed. Off to a late start, that deterioration in merger market conditions accelerated once Merger Monday (Jan. 13, 2014) signaled to laggards that they’d better catch up or risk being left behind in their industries being radically redesigned via merger. This catch up was so dramatic in fact that at the beginning of 2015, I indicated in my financial blogs that I was revising the projected end date of the present business-merger wave from 2018-2019 to a considerably earlier Q4 2016-Q2 2017. May 2014 marked an inflection point when target company prices had soared so dramatically that deal advantage was now solidly commanded by Sellers, rather than buyers.[62] Maverick corporate overpayers citing non-financial rationales are eventually disciplined by markets and/or their Boards; such a perilous (for acquirers) post-inflection period rarely lasts two years before Merger Endgame is threatening, once again. Throughout 2015, my financial blogs were often led by the phrase “2015=1999”: a deliberate reference to the similarities between Dot-Com I’s 99 Percenter zombie firms and Dot-Com II’s slightly more respectable ‘unicorns’. The date was/is deliberate: the year before the M&A (and general stock market) implosion. By December 2015 – the start of final Phase IV of the Merger Megaboom / Dot-Com II – the key LEI/CEI relationship was trending towards reversal. Both of the indicators traditionally foretelling a business-merger market past its prime, CAPE and Buffett Indicator – had moved from flashing yellow to beginning to flash red. Cheap financing would disappear soon, both because of the Fed’s first rate increase series since 2007, and because of a collapse in high risk junk bonds not seen since the collapse of Drexel Burnham in Phase IV of LBO Wave 1 (1982-1990). See Figure 1.6 The extent to which the Fed chokes stock and merger markets depends in large part on the pace of tighteningSource: Based on data from S&P Dow Jones Indices, Ned Davis Research . Figure 1.6 The extent to which the Fed chokes stock and merger markets depends in large part on the pace of tightening Source: Based on data from S&P Dow Jones Indices, Ned Davis Research But no factor has been more critical to the truncation of the Endgame date for the present business-merger wave (IV) than the absence of supporting capex, as shown in Figure 1.7 Ground effects false recovery? Capex shortfalls mean an anemic recovery, despite this cycle’s advanced ageSource: Based on data from the Bureau of Labor Statistics. Figure 1.7 Ground effects false recovery? Capex shortfalls mean an anemic recovery, despite this cycle’s advanced age Source: Based on data from the Bureau of Labor Statistics Simply stated, there has never, ever been a sustainable recovery with inadequate investment in capital equipment aimed at improving efficiency and facilitating access to new markets. Significant gains in labour productivity are limited to the first half of the cycle – by Dec. 2015, that source of improvement was entirely depleted. What’s left? My phrase in my blogs since mid-2015 has been ‘ground effects’ market. When a plane is initially trying to get off the runway, it may initially be supported by a temporary effect which enables the vessel to glide over the surface—the basic principle in hydrofoils. But neither plane nor hydrofoil can actually fly at this point. As soon as the propulsion (quantitative easing?) is shut off or substantially reduced, the craft comes back to earth. Some might imagine that the recovery itself is a house built on quicksand. 15.1.2 Whipsaw: Merger market entry and exit missteps 2016=2000 Can YOU say "whipsaw"? Incr in mergers frenzy by consumer products & retail execs (EY Capital Confidence Barometer) @pondbridge (my Twitter-based financial blog) Dec. 22, 2015 [63] W/final Ph 4 beginning, mergers idiot season starts. 'Intent to acquire' indices peak: whipsaw ahead. Think odd-lot short index in stocks @pondbridge (my Twitter-based financial blog) Dec. 22, 2015 Second only to overbids relative to realistically achievable synergies, mis-timing is the leading overall cause of merger failure from the perspective of acquiring companies’ shareholders. Behavioural mis-steps (aka, acquiring with the heart rather than the head) are part of whipsaw errors at both ends of the M&A cycle, although the root causes differ. The Merger Market Entry Error: Chronic, self-congratulatory laggards applaud their own prudence Question 1: Why do supposedly knowledgeable corporate top executive consistently miss half or most of merger cycles, jeopardizing the success of their M&A programmes? This is no mere theoretical query. Although the signals pointing to an unstoppable return of conditions favourable to successful mergers first flashed as early as Dec. 2011, and Spring 2013 brought undeniable event studies-based evidence of volcanic-like merger demand, many would-be acquirers delayed until after Jan. 13, 2014 – Merger Monday – to begin acting on their M&A plans this cycle. As lemmings rushed, the late realisation of being two years late pushed share prices of targets and premiums skyward. By April of 2014, advantage had shifted to sellers, meaning that many acquirers had only a very brief 3-4 month window to achieve a ‘sweet spot’ deal: at a price and quality likely to beat M&A’s miserable 33% performance record. What’s the explanation – or more accurately, the excuse, for this value-destructive corporate merger programme mismanagement? Figure 1.8 Behavioural mistakes throughout the cycle Source: Unattributed figure from various online sources deals with stock markets not merger markets, but the two do run in parallel and at the end, collapse at about the same time. The psychology of seeking excessive confirmation is compelling. The laggard imagines that he/she is being highly responsible and conservative by always seeking more affirmation. The truth is the exact opposite. By insisting on an unreasonable level of confirmation, the foot-dragging acquiring company CEO radically increases merger risk, by missing bargains earlier in the cycle. Figure 1.8 Behavioural mistakes throughout the cycle Source: Unattributed figure from various online sources 15.1.3 Getting out early enough to escape the carnage of merger market collapses Snapchat's failure to accept overbids by Facebook, others (before unicorn private valuations were debunked) is this cycle's biggest management gaffe. @pondbridge, Dec. 29, 2015 (slightly modified) 2016 (DotCom2) = 2000 (DotCom1) as both SPX & full year an US #mergers peak in 2015. SPX: 1st an loss since 2008 [64] @pondbridge, Jan, 1, 2016 December 2015 marks the beginning of the fourth and final phase of Dot-Com II / Merger Megaboom, the unofficial name of the M&A wave starting at the end of 2016. It was not one, but the combination of aforementioned factors but rather a combination that affirm that merger’s best days are in the past, this cycle. SPX and merger volume apparent peaks during 2015. CAPE and Buffett Indicators (BI) approaching dangerous heights. A flip in the LEI/CEI relationship. The Fed first rate increase since ’07. Chronic capex shortfall. Bull market period exceeding historical precedents. Soaring junk bond rates, indirectly draining capital for other higher risk investments such as mergers. Any one or two of these factors might be dismissed or at least minimized. But all of them? The general in the trenches doesn’t have to wait until the enemy is engaging in hand-to-hand combat to know that it’s time to bear a hasty retreat. The penalties of late exit are even more sever than missing the merger wave’s early sweet spot in the first two-thirds. Spotting a classic exhaustion gap of the (then) key NASDAQ index in mid-Feb. 2000 (about a month after the disastrous AOL/TimeWarner merger), I warned in my blogs at that time to depart the merger market immediately.[65] Those not heeding that early signal encountered a ‘falling knives’ market. Potential deal targets plunge in value: not because the sellers suddenly decide to charge more reasonable prices, but instead, because merger prospects have dissolved and the anticipatory purchase premium embedded in the possible remaining targets’ prices has evaporated. Serial analyses of merger viability (Damodaran, IVE in Clark & Mills 2013, Chapter 3) must now incorporate a recession by Year 3 or lose all credibility. Will acquirers get out soon enough to save their skins? Or will the syrupy, self-serving assurance that things aren’t that bad win the day? It is normal that disagreement exists at the critical time to depart (See Getting out: Past waves of the present Volker Post-1980 era and present Source: © Pondbridge Ltd. 2015-2016, all rights reserved). GET OUT consensus only occurs a year or so after the collapse, when it’s too late. Getting out: Past waves of the present Volker Post-1980 era and present Source: © Pondbridge Ltd. 2015-2016, all rights reserved Reflective exercises - 1 Is it an exaggeration to say that an acquirer can succeed by buying its target in the first of the four merger wave’s phases? Capture your thoughts in the space below. Show Workbook Which do you believe is more important in terms of re-setting conditions conducive to the return of enthusiasm for mergers: behavioural factors (return of optimism, fear of missing the merger boom) or fundamental factors (such as several of the ‘perfect storm’ conditions noted in the Clark reading assigned for this topic)? Topic summary Topic 15 has given you an introduction to what mergers and acquisitions are. Both a merger and an acquisition need to provide company valuation so this was the main focus of our learning. We have introduced the term ‘merger wave’ to describe the process in which management teams and boards of directors ‘can’t avoid’ closing an M&A deal even if it is not 100% financially justified because of industry inertia. You would be surprised how many finance teams fail when performing valuation of synergies, especially when forecasting those changes that will support the new company’s growth through additional revenue-generation or reduced costs. Hopefully you now understand some of the reasons for this failure! The next topic will drive us through the measurement of merger success from the acquirer’s perspective. Keep the enthusiasm! 15.1 Understand the behavioural and merger market financial reasons why the ‘urge to merge’ tends to return after the deepest recessions. Date 15.2 Comprehend merger valuation lessons from the first post-1980 business-merger wave, and the wave of 1996–2000. 15.3 Identify key aspects of the four-phase pattern characteristic of each of the four business-merger waves since 1980, including the present, from both buyers’ and sellers’ perspectives. 15.4 Understand how increasing acquisition purchase premium levels increases the risk of acquisition failure in later phases of the cycle. Topic 16 : Measuring merger success – the acquirer’s perspective Introduction Simply stated, the phrase ‘merger valuation’ (referred to in Clark as ‘MergVal’) refers to a systematic, standardised, codified and widely embraced (by the financial community at large) methodology for determining whether mergers are successful or not. This helps us to distinguish this cycle’s likely ‘winners’ from the rest of the deals. As we will study in this topic, merger success is directly related to the acquisition purchase premium (APP) paid by the acquirer. The system for measuring merger success (and who measures it) may not appear to have changed much in recent times, but this perception would be wrong. In an article in the Financial Analysts Journal ‘Earnings per share don’t count’ (1974), the author Joel Stern confirmed the essential relationship between purchase premium (deliberate overpayment to secure control of the M&A target) and synergies (post-merger savings and efficiencies resulting from the combination, conservatively and independently determined). If you’re going to pay over the market price for any asset (including a company, which is a sum of assets and liabilities), you have to make up for it somehow – otherwise the deal won’t be able to reach break-even, or in other words, generate returns above its costs. The problem is that Stern’s basic idea progressed to the stage of best practice diagnostic standard until it was examined against the primary alternatives in Clark (1991 and 2012), Sirower (1997) and Damodaran (2005). In the diagnostic field, all of these authors reiterated the importance of synergy versus the premium difference paid (and thus the name of the principal form of the analytical approach is ‘value gap’). Nevertheless, and despite the obvious findings that high APP lead to M&A losses, M&A deals continue the trend in which two-thirds fail. Along these lines, the most important recent development in the merger diagnostic community is the acceptance of the two ‘preference methods’ described inMasterminding the deal as the methods for evaluating individual merger success based on the perspective of the parties putting up the risk capital (the continuing shareholders of the buying firm). This means that acquiring companies need to be clear what the objective of the M&A deal is in order to quantify synergies and ensure that they are worth the deal. For example, let’s think of a company whose source of revenue is the generation of pharmaceutical patents. This company may feel tempted to acquire other companies with a pipeline of new products that could be turned into patents. This would be the source of additional revenue that the company needs to analyse carefully (future cash flows from the additional patents if the M&A were to take place). Today, all the most credible and respected sources of merger valuation base analysis on synergy-versus-premium methodologies, some specifically citing Clark and Mills’ value gap and incremental value effect as specific variants. From Breakingviews to FT Lex, Credit Suisse to The Economist, the unsubstantial method of valuation (one not based on real forecast of synergies) is exposed and corrections are made by the financial community as a whole. Essential reading Read both of the two Essential Readings for this topic and then develop your responses to the quiz and self-assessment questions that follow. Clark, P. ‘Chapter 2: Getting the merger valuation analytical methodology right’, adapted from Clark, P. and R.W. Mills Masterminding the deal: breakthroughs in M&A strategy and analysis (London: Kogan Page, 2013) © Pondbridge Ltd 2013. Dobbs, R., B. Nand and W. Rehm 'Merger valuation: time to jettison EPS', The McKinsey Quarterly (2005), pp.82–88. Remember that all the essential reading for this programme is provided for you. Click the link (which may take you to the Online Library where you can search for a journal article) or click ‘next’ to go to the next page and start reading. Clark, P. ‘Chapter 2: Getting the merger valuation analytical methodology right’, adapted from Clark, P. and R.W. Mills Masterminding the deal: breakthroughs in M&A strategy and analysis (London: Kogan Page, 2013) © Pondbridge Ltd 2013. All rights reserved. The right of Peter J Clark and Roger W Mills to be identified as the authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Reproduced by permission of Kogan Page Ltd. 16.1 Clark Chapter 2: Getting the merger valuation analytical methodology right 16.1.1 Introduction Author’s note: The majority of the chapter excerpts included here were developed over two years prior to ‘Merger Monday’ (MM: 13 January 2014). As stated in Chapter 1, that multiple-transaction spike marked the approximate mid-point of the present business merger cycle (12/11 Q4 2016–Q2 2017), the fourth and final M&A cycle of the post-1980 Volcker era. Amongst knowledgeable M&A analytical practitioners, today’s two prevailing, closely-related approaches – Value Gap (VG) and Incremental Value Effect (IVE) – dominate. Whilst that doesn’t completely forestall attempts by boosters of suspect – that is, low success probability – deals[66] to try to improve their prospects of reaching a close either through dodgy assumptions and/or resurrecting suspect past rationales since discredited. However, any such ruses involving major corporations are today almost immediately spotted by the influential thought leaders in the merger valuation (“MergVal”) analytical practitioner field. That group includes but is not limited to top-rung media-analytical groups such as Reuters Breakingviews, Financial Times (Lex and Lombard columns), MarketWatch (WSJ), The Economist, plus some other individuals who today embrace merger’s Best Practice methods, at least in a general manner.[67] Accordingly, the major chapter expansion parts added herein for my new research in 2014-15 concerns determination of specific components of today’s two prevailing methodologies. Those elements are Acquisition Purchase Premium (APP) and Net Realisable Synergies analyses (NRS). Both APP and NRS are today still frequently mis-calculated, and not just because of debatable assumptions. Dealmakers and other prosletisers of marginal deals are motivated to close the maximum number of fee-generating transactions as their top priority, sometimes regardless of consequences to the buying company and its owners (See ‘Alex’ cartoon in Chapter 1). Based on pre-2005[68] precedent, these middlemen may well have figured that the then (a) expansive range of momentary plausible merger ‘success’ criteria bouncing around like pinballs in those years, plus (b) little real knowledge of what terms such as “synergies” mean, provided them with the necessary cover to essentially make up whatever deal synergy numbers were necessary to ensure a closed deal. But that was then. This is now. As recently as a decade ago (in 2005), such mis-practice might have been ignored by the analytical financial community, as media and institutions often had little more to go on than the spin of the acquirer, its bankers and their hired gun financial public relations (FPR) firm to inform ‘success’ or ‘failure’ assessment of the merger in question. But not now. Today, involvement of a FPR instead shouts ‘troubled deal’ and numbers that are probably not to be believed. Today, a half dozen independent, proficient merger valuation practitioners craft their own unbiased and informed determinations of a merger deal’s attractiveness and financial viability, shaped by modern MergVal principles, several of which are summarised in this chapter. In particular, APP undercounting and NRS over-estimations (the two most frequent manipulations of importance to merger valuation) are likely immediately spotted.[69] Spring 2012: Merger’s now prevailing synergy v premia evaluation is codified. Based on that, >90% of today's newly proposed M&A deals are NON-viable. @pondbridge (P. Clark Twitter professional financial blog), Jan. 1, 2016 (slightly expanded and adapted) Modern MergVal focuses first and foremost on the essential financial interests of that single large group whose collective opinion matters most when it comes to matters concerning their corporation’s next major acquisition, which will likely be that firm’s largest total investment ever. Who are they? The continuing[70] shareholders of the buying company. Because it is the owners of the business who ultimately put up the risk capital critical to acquiring the target and thus securing the transaction.[71] Today, the prevailing interpretation of that group’s financial self-interest is reflected in the interlinked (as shown in Figure 1.4, Chapter 1[72]) notions of APP and NRS. When and if Net Realisable Synergies exceed Acquisition Purchase Premia for the same deal and involving the same two prospective merger partners, that buyer is deemed to have offset the deliberate overbid which necessary in order to secure control of the target company. In other words that deal is deemed to be a success.[73] That discredited past merger valuation methodologies might re-appear from time to time like so many bad pennies matters little.[74] Merger Valuation Best Practice is no beauty contest subject open to any entries. Nothing alters the foundation considerations which determine M&A success or failure.[75] And then there are the bankers and others who are ignorant of (or ignore) MergVal established criteria. But that isn’t going to stop them from bombast about their self-described genius in spotting ‘winning’ deals. The favoured approach of M&A diagnostic Neanderthals is multiples. Limiting the potential maximum bid for a target based on Cash Flow (CF) multiples of supposedly comparable companies & transactions might provide provocative extra insight, but it is Azofra/AMS’s 38% APP ceiling plus an independent verdict of deal success or failure based on APP-versus-NRS that matters. For when it comes to multiples, the word “comparables” often applies in name only, for ‘multiple’ reasons (Luehrman, 2009).[76] Equally important, multiples are not measurement criteria per se, but instead is a metrics indicating past actual performance, even when extrapolated into the future. Thus it is understandable how it is today that in company valuation, multiples at most a secondary, confirming role, despite continuing extensive used by investment bankers and a shrinking number of corporate managers and analysts. 16.1.2 In setting M&A Evaluative Criteria, the WHO question is of paramount importance Much of the debate (about merger-driven restructuring of the UK retail sector) has related to the benefit, or otherwise, to the customer,… about the effect on competition… on employees, … (or on) suppliers. Surprisingly one stakeholder group that appear to have been taken for granted in this debate are the owners of the companies involved, and in particular on the shareholders of the acquiring firm. Burt & Limmack 2003, 148. [77] The gains to acquirers’ shareholders are usually zero and often even negative (Berkovitch and Narayanan, 1993; Bradley, Desai and Kim, 1998; Sirower, 1997; Varaiya and Ferris, 1987). Mueller & Sirower (2003), 374[78] Setting merger performance evaluation criteria – that is, determining whether a specific deal is a ‘success’ or ‘failure’ – begins with identifying the critical criteria-selectors. That’s the essence of the WHO? question. In the past, concepts about how best to measure merger performance have been almost as numerous as the number of self-described M&A ‘experts’. But a biz-TV talking head’s quip isn’t fact; today do not apply APP-NPV criteria today likely face a challenge to raise their diagnosis approach up to standard .[79] Continuing[80] shareholders of the acquiring firm are in firm command when it comes to methods for determining M&A success. Shareholders’ merger expectations are singularly expressed in terms of the realistically expected net financial returns back to them, from that specific transaction. [81] Burt & Limmack (above) concur, affirming the primacy of interests of shareholders of the buying company when it comes to determining M&A ‘success’ or ‘failure’. B&L are joined by others, including but not limited to: ⦁ Tuch and O’Sullivan. (2007, 142): “Shareholders are the ultimate holders of the rights of organizational control. (Jensen 1984)” ⦁ Sudarsanam (2002, 88): “According to the finance theory perspective, managers’ decisions are aimed at enhancing shareholder wealth. This means that the return from investing in the acquirer’s stock is at least equal to the cost of capital. If an acquisition fails this… test, the shareholders would have been better off investing their capital in another investment opportunity.” [⦁ 82] ⦁ Hogarty (1970, 317): “(for) a merger (to be) considered to be successful, (it) must increase the present value of the owners’ interest in the firm…”Hogarty defines merger success in terms of the present value of future returns to the acquiring company’s shareholders. He is echoed by Norton in the April 1998 issue of Barrons.[⦁ 83] Sudarsanam gauges the buying firm’s minimum required return rate relative to that company’s Weighed Average Cost of Capital (WACC). Thus in some ways, the evaluation of major external investments (mergers and large strategic alliances) is similar to the approach used in financial assessment of internal investment, aka capex. Merger success is not whether the deal is consummated. Instead, merger success (or failure) reflects whether expected returns to the continuing shareholders of the buying firm exceed its internal financial return minimum threshold, usually WACC. Bankers and others (even the occasional scholarly paper author) who err in referring to closed transaction as successful have it all wrong. For if the transaction is value-destroying based on prevailing MergVal criteria, then such a truly ‘successful’ transaction is a nul set. 16.1.3 Overview: Four alternative merger valuation methods The four primary quantitative (financial) merger valuation methods as described in this chapter are summarized in The Four Primary MergVal Alternative Methods SummarisedSource: © Pondbridge Ltd. 2012-2013, all rights reserved . The Four Primary MergVal Alternative Methods Summarised Source: © Pondbridge Ltd. 2012-2013, all rights reserved Event Studies (ES) are developed from widely-available public company share statistics and other financial market information. Primarily because of the method’s ample availability of data for calculation, ES persists as valuation academia’s ongoing approach of choice. ES also sometimes helps in identifying major underlying changes in the merger environment.[84] But ES’s use is declining with several other merger diagnostic groups, due to three considerations: (a), increasing recognition that departures from Rational Market Theory – a key to the ES analysis – have today become so frequent that RMT has, for practical purposes, declined from status as THE Market Rule to merely a frequently occurring scenario; (b), 2012 codification of Value Gap (this chapter) – type MergVal methodology – around since 1974 but before ’12 lacking consistent calculation integrity and standards – pose a significant, relatively recent challenge to ES; and finally (c) the significant limitations of ES (described later in this chapter), particularly the absence of a true control case condition. As applied to MergVal, (c) refers to the fact that that it is sometimes almost impossible to isolate the separate effect of a merger announcement on stock price when several other influences could also be involved. Total Shareholder Return (TSR): Accompanied with a corporate Cost of Capital (WACC) reference,[85] TSR provides one indication of returns as perceived by the acquiring firm’s shareholders – so long as one ignores the contentious embedded assumption that all measurable mergers are round-turns: that is, involving both a purchase and a future sale. Distortions may arise with outsized dividend payouts and/or buybacks.[86] Comparing one TRS result with others may be problematic, particularly when the deals being compared happened in different phases of their particular cycle. Value Gap (VG). This is arguably today’s most visible and broadly-applied measure of merger performance in terms of success or failure. Today, it is rare that a major deal is announced in which the synergies versus premium VG guesstimate is not provided; particularly as such an omission might raise immediate concerns in the financial community of overpayment by the acquirer relative to defensible net synergies.[87] Incremental Value Effect (IVE): Damodaran’s 2005 seminal JoF paper a pre- and post-merger announcement comparison based on two sets of company DCF analyses is a predecessor to my IVE method as detailed later in this chapter. IVE addresses a central question of proposed mergers: Are shareholders of the acquiring firm better off proceeding with the deal, or not? As with all projection-based methods, multiple assumptions about the future are required in IVE, reducing the attractiveness of this method to some detractors. [88] 16.1.4 Event Studies (ES): Exceeding the limits of Rational Market Theory? The efficient capital market hypothesis predicts that any new information, like the announcement of a merger, leads to a quick adjustment of share prices to reflect unbiasedly the future changes in profits the new information purports. Mueller & Sirower (2003) 374. The expansive Event Studies (ES) category of MergVal approaches emerges from the observation that when a publicly-traded company announces possible purchase interest in a target, the would-be buyer’s share price often declines by nearly the amount of the APP, while the target company’s share price rises, in (approximate) mirror fashion. Why this effect? Besides possible short-term stimulus as the Expression of Interest (EOI) announcement prompts speculative trading, the concept of market efficiency appears to apply: ⦁ In overall terms (that is, incorporating the combined interests of both acquirer and acquiree), mergers tend to improve efficiency (aka, are value-creating) presuming scale economies and elimination of overlapping costs and other easily achievable synergies. One caveat: Acquisition Purchase Premium effect is ignored. ⦁ But as Christopher et al. observe, most these merger efficiencies (as reflected by the APP) accrue to the target: "On average, the buyer pays the seller all of the value generated by a merger, in a premium of from 10 to 35 percent of the target company’s preannouncement market value." (2004, 93) In a merger deemed to be successful based on ES-category criteria, the acquirer’s share price soon rises after an initial dip. This is thought to reflect the financial community’s improved understanding of the attributes of the target and the characteristics of the merger proposal itself, plus new confidence that the combined entity is better off than if no deal had occurred because of sufficient post merger improvements, aka synergies. But if the bid price is viewed by a significant number of influential MergVal market observers as ‘fully rich’ (read: gross overpayment), the reasoning is that available & achievable synergies do not offset the purchase premium hole that buying management have dug for itself. The buying company’s share price remains suppressed relative to its pre-merger announcement (aka, Expression of Interest (EoI) date) level. A persistent post-EOI slump may also reflect (a) low financial market confidence in the acquiring firm’s management team’s ability to achieve the prosletised synergies, and/or (b), lack of confidence that synergy number (especially when the source is solely the acquirer’s entourage). Concerns arise about both short- and longer-term variants of the method also exist, helping explain ES’s isolation amongst merger valuation scholars. MergVal-educated corporate management and M&A practitioners present and past (e.g., Bruner (2002) 94-95, Brouthers et al. (1998) and Epstein (2005) expressed their doubts about use of ES in assessing merger success or failure. ⦁ Shorter-duration ES. In the case of ST Event Studies, notion that a judgment about the success of a specific deal is signaled by merely a few days to a couple of weeks’ of share price fluctuations defies credibility. At the deal’s close, today’s acquiring company’s CEO at best has an approximate hypothesis of the synergies achievable, so presuming market omniscience (under customary semi-strong notions of market efficiency (SSME)) is a big stretch. ⦁ Longer-duration ES. Longer-term ES is based on more extensive base data, but the threat of data overlap and contamination increases with the duration of the analysis period. The acquiring company’s share price is not a single-issue referendum on any action or change in circumstances, including a proposed merger bid. As the number of days from announcement date (EoI) to analysis date increases, it becomes increasingly difficult to isolate share price movement relating to one past acquisition from other influences on share price. 16.1.5 Total Shareholder Return (TSR): Only appropriate for use by Financial (PE) Round-Turn and similar types of acquirers? I bought all of Company A’s shares in Year 1 @ price of $70 per share, then sold those same shares three years later for $90/share. Was this round turn buy-and-sell transaction successful? Depends on whether or not that total annualised return over that period exceeded the greater of WACC or analyzed opportunity cost. My 2011 class TSR illustration (hypothetical) Total Shareholder Return (TSR) method resembles the individual investor’s round turn—buy and then sell at a latter date— sequence in making stock picks and then selling out a few years later for a gain or loss (hypothetical, above). Whether buying 100 shares of IBM or the entire corporation, cash-on-cash returns attributable to that investment are recorded from the time that the target’s shares are acquired until the date that interest is sold. The difference in share proceeds plus dividends received are then transformed into an annualised rate of return over that buyer’s period of possession. For the acquirer of the entire target company, those returns are expressed by the change over time in market capitalisation (share price appreciation times the number of shares outstanding) plus total dividends received,[89] as shown in the base TSR ratio (Basic Equation: Total Shareholder Return (TSR)). The calculation is simple and deal-specific. Some might instead describe TSR as simplistic, as the ratio’s ease of calculation is offset by some other major deficiencies, including but not limited to: ⦁ No phantom share sales. In its usual form, TSR only considers those acquisitions which are later sold, spun off, or otherwise disposed.[90] But what about successful acquisitions which are not sold because they remain an integral part of the acquired company? For a financial (that is, non-trade) acquirer buying companies on a portfolio basis (PE) or a roll-up[91] firm such as Canada’s Valeant, this exclusion poses little concern. Not so for the operating company which buys the target and then holds on to it forever. ⦁ Comparability. TSR comparisons are often problematic, both to that buyer’s prior transactions as well as to outside alternative ‘comparable’ transactions by others; upon careful examination, the latter often turn out not to be so comparable, after all. Basic Equation: Total Shareholder Return (TSR) Source: © Pondbridge Ltd. 2012-2013, all rights reserved 16.1.6 Value Gap (VG): Do synergies offset the price premium necessary to financially justify acquiring this target? It is the NPV of the acquisition decision—the expected benefits less the premiums paid—that markets attempt to assess. M. Sirower (1997) 10. A’s acquisition of B or B’s acquisition of A is in fact good for the buyer’s shareholders only if synergism is expected. And the synergism must be at least large enough to justify the premium paid above the seller’s current share price. J. Stern (1974) 39. Value Gap (VG), the third merger valuation methodology in the summary The Four Primary MergVal Alternative Methods SummarisedSource: © Pondbridge Ltd. 2012-2013, all rights reserved , reflects the commonsense notion that for a deal to be successful, post-merger (PMI) improvements in the newly combined company – referred to here as Net Realisable Synergies (NRSs) – must exceed the Acquisition Purchase Premium (APP) paid. [92] As the quotation from Stern’s seminal 1974 article “Earnings Per Share Don’t Count” (above) describes, this MergVal approach originates with the earliest days of management’s embrace of Free Cash Flow (FCF)-based company value analysis beginning in the mid-Seventies. [93] Following (a) broad-based acceptance of the reality that historically, Most Mergers Fail and (b) the spectacular collapse of some so-called ‘friendly’ transactions around the end of the Millennium such as Daimler-Benz’s acquisition of Chrysler (1998) and AOL’s purchase of TimeWarner (2000)[94] financial writers of an investigatory bent became far less inclined to unquestioningly explanation that because of strategic or positioning considerations We did not overpay, even when ES results screamed otherwise. Today, nearly every major acquisition is accompanied by an analyst or reporter’s rough math about APP relative to synergies, either to support the contention that the acquirer has overpaid for the target, or the opposite: that the deal is value-accretive. Value Gap is one of closely-related valuation methods listed in The Four Primary MergVal Alternative Methods SummarisedSource: © Pondbridge Ltd. 2012-2013, all rights reserved which (a) reflect synergy-versus-premia criteria and (b) incorporate Discounted Cash Flow (DCF)-based methods. The other is Incremental Value Effect (IVE), also described in this chapter. ⦁ In VG, projected synergies from the envisioned business combination are discounted back to the present, ideally at the combined firm’s projected Weighed Average Cost of Capital (WACC) rate. ⦁ In IVE, both standalone and combined company projections apply the two-stage Discounted Cash Flow (DCF2S) approach already well-established in company valuation. (Mills 2005, 73) Value Gap (VG) Calculation Dynamics Based on the simple Value Gap method, a transaction is considered to be value-destroying (and thus, unsuccessful) when and if the APP exceeds the present Value of Net Realizable Synergies ,[95] as depicted by the “APP” and “SYN” columns in Value Gap (VG): Overview Source: © Pondbridge Ltd. 2012-2013, all rights reserved . Value Gap (VG): Overview Source: © Pondbridge Ltd. 2012-2013, all rights reserved VG is the most visible and widely-cited form of synergy-v-premium analysis approach today. In theory and correctly & fully applied, proceeding with deals only when synergies warrant (independently and conservatively calculated) could significantly reduce M&A’s historical two-thirds failure rate. But that would also mean a slump in deal fees of up to two-thirds. Thus in dealmaker-dominated M&A markets, there’s considerable resistance to this method if and when the answer does come out the way the CEO ego-acquirer or his advisors hoped. In the fourth and final stage of a merger wave (see Chapter 1), when overall success percentages trend towards single digit levels, those parties emphasising deal closes over deal success might either (a) ignore Value Gap altogether, (b) materially miscalculate one or both components of VG, or (c), invent a bespoke substitute that’s easier to manipulate and thus potentially more accommodating to a headstrong acquirer. Several other considerations contribute to this real world practice of side-stepping VG’s merger success (or failure verdict). There include but are not limited to the following: ⦁ Business media sometimes divert management’s away from the essential and towards irrelevant criteria when arguing that bids conceivably have been higher, based upon factors including but not limited to financing availability, reductions in expenditures including capex and/or possible dispositions. For reason, note that in Table 2.1 there’s NO criteria based solely on ability to overspend. ⦁ Merger decision makers’ cold feet. What’s an even more sackable M&A-related management gaffe than missing the present runaway acquisition boom that started at the beginning of 2012 by a full two years? How about abandoning a merger chase once started? For the acquiring firm’s CEO, this is a lose/lose predicament. Even if the deal is not pursued for legitimate operational or VG-related reason[⦁ 96] (e.g., prices have soared to the point where a close at this level would be value-destructive), some Board members, angry at coming up empty-handed and with limited comprehension of MergVal basics may complain that the CEO should have anticipated this in advance, noting the costs to the buying company of the aborted bid. Two or more missed closes often means that the chief executive should begin preparing for the sack; ‘to spend more time with his/her family’.[97] Better to just go ahead with the deal anyway, many wannabe acquirer CEO may reason. Implementing Value Gap: Practical Considerations (Illustrative) Source: © Pondbridge Ltd. 2015-2016, all rights reserved Particularly when the laggard acquirer is off to late start with his M&A programme, arguments that late deals are more precarious than ones earlier in the cycle tend fall on deaf ears.[98] To that chief executive, what matters is that the target is a quality company, little more. His own company’s share price swings up and down over the business-merger cycle, after all. Plausible, yet flat wrong. Timing is critical to merger success. The slow-to-merger-market CEO knows full well that his prize target could have been acquired earlier in the cycle at much lower price, but wasn’t. As excessive price relative to realistically achievable net synergies is the Number One reason for merger failure based on prevailing MergVal criteria, a lower price might have made all the difference between success and failure (Implementing Value Gap: Practical Considerations (Illustrative)Source: © Pondbridge Ltd. 2015-2016, all rights reserved illustrates deals success differences between the first merger wave’s phase (I) and the last (IV)). That illustrative exhibit also shows that certain types of failed deals can never be spun to appear to be viable. Starting from the lowest ranked of the four CLOSED deal archtypes: ⦁ Immediately Discredited (ID). My informal phrase is ‘deals that blow up on the launch pad’. No ambiguity here as there’s near-immediate and almost universal condemnation of the failed deal. The question of disposal at loss or write-down is not a question of whether, but rather when. On a percentage basis, these dogs fight for the crown (?!) of worst deal ever: Terra Firma/EMI, Yahoo/Tumblr, HP/Palm OS, Microsoft/Nokia Phone[⦁ 99], Dell/EMC[⦁ 100], BofA/Countrywide Financial and of course that biggest of all merger trainwrecks, AOL/TimeWarner. ⦁ Decisive Failure (DF). At least during the first month or so following the deal’s close, at least one or two merger evaluation thought leaders who give the deal an outside chance based on some plausible arguments. Pfizer/Allergan might work if cost cuts approach Pharma’s instinctive 25-30% funny number overcounting of synergies, if even one surprise blockbuster emerges and if Obama’s and Clinton’s sabre rattling about inversions turn out to be nothing more than that. ⦁ In a Tolerable Failure (TF), there an outside chance that the numbers might indicate a greater than a 20% prospect of merger success, but only if that acquirer’s bloated in-house lipstick-on-a-pig numbers are (a) applied and (b) are minimally plausible. Such ‘outside chance’ deals include combinations such as BT/EE, AB InBev/SAB Miller, Facebook/WhatsApp, Apple/Beats plus several of AstraZeneca’s deals consummated after management’s mistake of turning down Pfizer’s overbid. Even Microsoft/Skype and Verizon/AOL.[⦁ 101] ⦁ Success Affirmed (SA), These are deals where the seller may face criticism for not holding out for high enough of a price. Nearly all of the Tier 1 independent merger performance diagnosticians agree: the deal is good to great: Hudson Bay/Saks[⦁ 102], eBay/PayPal, Berkshire Hathaway/Geico, Dow/DuPont[⦁ 103], Apple/Next, Facebook/Instagram[⦁ 104]. But some formative issues arise with both of key elements underlying VG and IVE MergVal methodologies. Acquisition Purchase Premium (APP) Best Analytical Practice (BAP) Issues Is the earlier of the two premia dates being distorted – deliberately or otherwise – by the buyer? Acquisition Purchase Premium percentages alone – often the only form that APP is expressed – is usually not adjusted for point in the cycle, even though it is not unheard of for share prices of a target companies to double or more, calculated from the beginning of the wave in Phase I (of 4) to say, the mid-point of Phase III.[105] Four APP Best Practice Determination IssuesSource: © Pondbridge Ltd. 2015-2016, all rights reserved summarises the top four Best Practice issues relating to determining APP. Consistency (D) makes common sense: now forewarned, the acquirer making a late phase acquisition with low success probability might be tempted to apply a more easily manipulated APP approach late in the wave, lest the star deal be exposed as a zombie. Four APP Best Practice Determination Issues Source: © Pondbridge Ltd. 2015-2016, all rights reserved A legitimate back-up role for multiples arises in (C). As both pre-bid target company shares and control premia ratchet upwards with time, risk rises that even the most carefully constructed APP percentage number might mislead. Multiples to the rescue: while applying a maximum or ceiling multiple of CF is rarely credible as a standalone measure,[106] a more limited role as a back-up to the core APP diagnosis may prevent the mistake that might otherwise go undetected. The Expression of Interest date (EOI, points A and B in the exhibit) is critical as acquirers and their handlers have been known to short-count the earlier of two dates used in APP calculation under rising stock market conditions. The objective? To artificially manipulate the all-important APP percentage downwards to something that plays better in the business press (as the leaders in the diagnostic field all apply their own APP calculations, that tactic might have worked in 2007, but the ruse rarely succeeds today). Synergies Moving beyond the buzzword name Companies that put priority on pre-deal synergy evaluation were 28% more likely than average to have a successful deal…. KPMG, 1999[107] (1999). The “S” (synergy) word has the unfortunate ring of something dreamed up by some slick management consultant. Nonetheless, synergy’s foundation conception in merger valuation is solid. Notions of expense synergies due to scale efficiencies or elimination of duplicative overhead or similar are long established. Even some of the more speculative synergy categories in Synergy Categories and Sub-Categories: An OverviewSource: © Pondbridge Ltd. 2015-2016, all rights reserved may contribute to the challenge of helping to offset some of the APP control premium amount. Synergy Categories and Sub-Categories: An Overview Source: © Pondbridge Ltd. 2015-2016, all rights reserved The first step in moving away from the buzzy name is to refer instead to Net Realisable Synergies (NRS). What does that mean? Figure 2.1 Synergies: “S” versus “NRS” difference graphically illustratedSource: © Pondbridge Ltd. 2012-2013 all rights reserved shows the answer, graphically. Figure 2.1 Synergies: “S” versus “NRS” difference graphically illustrated Source: © Pondbridge Ltd. 2012-2013 all rights reserved First, gross synergies are properly calculated on a Cash Flow (CF) effect basis only. Next, necessary adjustments are made: ⦁ Discounting. Nearly all those CFs occur at different times in the future. As a consequence, discounting at the acquirer’s WACC rate (or some instead apply a blended cost of capital rate for the new proposed combined company), is necessary, in order to distinguish the £100M projected savings expected at the end of Year 2 following the close as contrasted with the same amount from the same Year 5. The two are not the same; the present value adjustment shows that. ⦁ Continuity. While business media analysts are sometimes drawn to the simplistic approach of capitalising all synergies – in effect, presuming that they continue on an ongoing basis,[108] that approach may mis-state savings. Many synergies are one-offs; others, such as staff reductions of near-duplicate staff only effect synergies in the near-term.[⦁ 109] ⦁ Offsets. The word as used here refers to contra-synergies: charges that reduce the amount of realizable synergies (and which, for that reason alone, are usually conveniently overlooked by acquirers and their advisor-bankers eager to put their pending deals in the most favourable light. Examples include set-up and redundancy charges (as in duplicative services during transition) associated with that new IT system that a systems PMI specialist claims will halve ongoing data processing costs after the deal is closed. Or redundancy costs for staff let go. Are high bid prices (as reflected by elevated prices times high acquirer APPs) primarily to blame for the high continuing historical levels of merger failure? 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 surpassing 100 percent (e.g., IBM’s acquisition of Lotus)… The higher the premium is, the greater is the value destruction from the acquisition strategy. M. Sirower (1997) 14 We find an inverse relation between premia paid and shareholder returns to the bidder firm. V. Gondhaleker et al. (2002) 18[110] HP paid an astonishing 80 percent premium for Autonomy, a business software maker based in Britain. H.P. lost $12 billion in market value within 24 hours of the deal’s being announced… (For 3Par, H.P. paid) the highest premium ever paid: 242 percent. A.R. Sorkin, New York Times (Nov. 7, 2011)[111] Azofra et al. (2007, 4) suggest an upper Acquisition Purchase Premium percentage range for successful transactions of ~37 percent, That prescribed APP ceiling based on their research is almost identical to that from an earlier investigation by Andrade, Mitchell and Stafford (AMS 2001-2002, 103-120): 38%. Azofra et al’s perspective is not single-dimensional. The researchers contend that they were considering both parts of the Value Gap equation—both APP and S—in their analysis: “The purpose of this research is to test whether the price paid for takeovers is related to synergies expected or whether bidders are overpaying for the acquisitions.” (2) Compare the Azofra-AMS limits to Porrini’s research into APP percentages in transactions from 1990 to 2002: “Between 1990 and 2002, acquisition premiums averaged 53.2% with 40% of acquirers paying premiums of over 50% and 10% of acquirers were paying premiums over 100%.[112] (2006, 59) Both researcher groups in effect suggest that no deals should be attempted any later in the merger wave than Phase III, thereby placing a premium on the ability to accurately discern the transition points from one merger phase to the next. 16.1.7 Good Company Bad Price (GCBP); or, if the target company is excellent quality, is it justifiable to overpay? This might alternatively be referred to as the Huffington Post fallacy, in recognition of then AOL’s chief executive Tim Armstrong’s gross overbid in 2011 for the attractive and almost-profitable (at the time of acquisition) complementary company, Huffington Post (“HuffPo”). [113] The GCBP situation arises when the chief executive of the acquiring company impulsively 'breaks the bank' and conspicuously overspends in order to secure ownership of the star-quality target company. The object of this acquirer’s affections is either a promising firm such as HuffPo, or alternatively, an already established leader in its sector. The acquirer proceeding with these high risk deals is often either (a) a desperate company using the acquisition to deflecting attention away from its own slumping performance, or (b) a late phase acquirer eager to close a deal in the remaining phases of the merger wave, before its too late. There is little debate that the acquirer has paid what the financial markets understatedly refer to as a ‘very full price’. Additional proof of overpayment comes in the content of the acquirer’s announcements about Value Gap components, or rather, the absence of such disclosure. The buyer already knows full well that APP far exceeds any realistically achievable synergy amounts, and hopes to avoid new concerns about the value-destructive nature of this latest deal from analysts, reporters and biz-TV talking heads. 16.1.8 Incremental Value Effect (IVE): Two-scenario DCF analysis, adapted to mergers Most companies transacting M&As rely on discounted cash flow (DCF) models to value a target company (Bruner, Eades, Harris & Higgins, 1998). Schweiger & Very (2003) 1.[114] Incremental Value Effect method as described herein represents an adaptation of Damodaran’s two scenario method as described in his seminal paper, “The Value of Synergy” (2005). The major adaptation pertains to synergies, as the NYU Stern School professor excludes synergies which original target company management could have achieved but did not; such synergies are included in the IVE methodology. IVE involves merger valuation decisions made on the basis of comparative analysis of two alternative Discounted Cash Flow (DCF) projections: Scenario 1 presumes that acquiring and target firms remain separate companies. Separate Cash Flows projections are developed for each firm, along with separate costs of capital (WACCs) based on each firm’s separate capital structure and component costs. As there is no business combination, purchase premium and no synergies are disregarded. Scenario 2 presumes that the proposed merger progresses. Both Net Realizable Synergies (NRSs, inputs) and the Acquisition Purchase Premiums (APPs, outputs) amount paid by the buyer in order to gain control of the target are factored into the combined company’s projections period. The hybrid DCF discount rate reflects the analyzed postmerger WACC of the two companies together. Common practice calls for the Two Stage Discounted Cash Flow (DCF2S) approach to constructing each of the two scenarios. An initial period usually 4-7 years maximum (Explicit Projection Period, EPP) followed by an estimate of terminal value applying the Gordon Formula aka Continuous Value Formula, the cash flow (CF) version of which is expressed as Initial Year of Terminal Value Period CF (n1..n2..n3) in the numerator, divided by the summed firms’ (or alternatively, the combined firms’) analyzed Weighed Average Cost of Capital * minus the CF future growth rate. If (a) the Net Present Value (NPV) associated with Scenario 2 exceeds (b) the NPV of Scenario 1 to the extent that the excess returns exceed the acquirer’s cost of capital, then the deal appears to be value-creating. IVE resembles make-versus-buy decisions within companies: two alternative scenarios are developed and compared on a projected basis, with the scenario exhibiting the highest Net Present Value (NPV) result selected. Incremental Value Effect (IVE): Developing the Two Separate Scenarios Source: © Pondbridge Ltd. 2012-2013, all rights reserved The precedent of making major investment decisions on a DCF basis is well-established. Chances that the large proposed internal investment--a project or a capital expenditure—might proceed at the corporation without advance in-depth DCF analysis are miniscule to nul. Comparable rigour should arguably apply to mergers, as the corporation's largest external investment outlay. Topic summary M&A deals have been happening for many years now, but today we have more evidence that most of the gains are made by the target company instead of the acquiring one. Andrade et al. (see further reading) emphasise some of the reasons why mergers occur in the first place, such as operational and financial efficiencies including strategic reasons (i.e. to improve the R&A department, expand internationally, increase product offer) and economies of scale (cost efficiencies from eliminating duplications and improving processes and procedures). Financial reasons are also part of the M&A scenario: some deals happen to improve tax treatment for the final company, improve the quality of the assets to reduce the cost of debt or are simply able to change jurisdictions and therefore improve the tax treatment again. It is clear that the acquiring company has a strong belief that the potential M&A deal will generate additional income and this is why, despite the large ratio of failure, most finance departments feel motivated and ready to go ahead with M&A deals. This topic has emphasised the differences in the interest of the players involved in M&A deals from investment banks to the target or the acquiring company. The fact that investment banks don’t have responsibility after the deal is closed may push deals towards high APPs, making it more difficult to generate the expected synergies. Over-optimism and questionable merger valuation techniques have been explained in detail in this topic. Further reading These readings can deepen your understanding in key areas of importance covered in this topic, but are suggested rather required. You should therefore read them only if you have time. ⦁ Andrade, G., M. Mitchell and E. Stafford ⦁ ‘New evidence and perspectives on mergers’, Journal of Economic Perspectives 15(2) 2001, pp.103–20. ⦁ Azofra, S., B. Diaz and C. Gutierrez ⦁ ‘Corporate⦁ takeovers in Europe: do bidders overpay?’ Seventh Global Conference on Business & Economics, October 2013, pp.1–8. ⦁ Mueller, D.C. and M.L. Sirower ⦁ ‘The⦁ causes of mergers: tests based on gains to acquiring firms’ shareholders and the size of ⦁ premia⦁ ’, Managerial and Decision Economics 24(5) 2003, pp.373–91. ⦁ Variaya, N.P. and K.R. Ferris ⦁ ‘Overpaying in corporate takeovers: the winner’s curse’, Financial Analysts Journal 43(3) 1987, pp.64–70 Further reading will deepen your understanding in some areas but it is not required in order to pass the module. You may wish to consult the reading suggested here or others that you find, but please note that we cannot guarantee that Further reading will be accessible to you and we do not undertake to supply it via the Online Library. 16.1 Understand how the financial interests of the acquiring company’s continuing shareholders affect which merger valuation approach to use. Date 16.2 Comprehend why two APP versus NRS-related methods are the prevailing methodologies when valuing mergers. 16.3 Understand why two leading studies set nearly the exact same ceiling acquisition purchase premium of 38%. Topic 17 : M&A segmentation – spotting winning mergers’ critical characteristics Introduction The principle of monitoring salient characteristics to improve business performance has a long history of successful application in business and finance. From the second decade of the 20th century, efficiency experts sought to identify and then measure the precise combination of actions that resulted in optimal outcomes. Top leaders are frequently asked about the critical differences that set them apart from the underperforming pack of company Directors. Even though many parties claim to be able to gauge M&A success accurately, conflicts of interest may distort their conclusions, especially as deal intermediaries such as investment banks and advisors tend to view merger ‘success’ as synonymous with closed transaction volume only. As we have seen previously, this is a logical stance in an environment where advisors are almost never held accountable for substandard merger advisory despite the reality proven over several decades that more than two thirds of all mergers fail. In contrast, the concept of true relatedness (referred to in the first topic objective) refers to the systematic, objective assessment of individual transaction success or failure, on an independent basis. The identification, examination and then application of positive or negative attributes by a few leaders in M&A deals is arguably most obvious in the field of marketing. In marketing, there is continuous insight into the most profitable customers. This leads to seemingly endless data-gathering and analysis of factors such as disposable income, proclivity to spend, price-versus-demand elasticity and the appeal of particular packaging, advertising even colours in separating the higher growth/more profitable product or service from trailing ‘me-too’ imitators. The ‘Illusions of synergy’ extract from Carroll and Mui explains how to figure out which synergies to pursue and which to eliminate. For example, some costs that are expected to be eliminated will just be moved to a different budget. Another example is when new management discipline needs to be implemented but it never is. This leads to questions about whether there is a real need for an M&A deal – are these synergies realisable through a partnership agreement? So what other field of business endeavour is more deserving of this segmentation approach than one in which two-thirds failure is the historical rule over many decades? Modern M&A segmentation analysis goes back to Coley and Reinton’s 1988 study entitled ‘The hunt for value’, one of your three essential readings for this topic. You will learn that some of the main reasons for merger failures include not anticipating cultural differences or not learning from past deal failures. As shown in your essential readings, another leading reason is the historical lack of segmentation frameworks to identify candidates for merger opportunities. Without this segmentation process, the acquiring company’s top management team moves ahead without a clear objective. Since Coley and Reinton’s study, merger segmentation has expanded in both depth and breadth: many of these areas are noted in Clark’s ‘Merger segmentation: an introduction’, another of this topic’s essential readings. Essential reading Read all of the essential readings for this topic and then develop your responses to the quiz and self-assessment questions that follow. Clark, P. ‘Chapter 3: Merger segmentation: an introduction’, adapted from Clark, P. and R.W. Mills Masterminding the deal: breakthroughs in M&A strategy and analysis (London: Kogan Page, 2013) © Pondbridge Ltd 2013. Carroll, P. and C. Mui Billion dollar lessons: what you can learn from the most inexcusable business failures of the last 25 years. (New York: Portfolio, 2009) excerpt from Chapter 1 ‘Illusions of Synergy’, pp.17–18. Coley, S.C. and S.E. Reinton ‘The Hunt for Value’, The McKinsey Quarterly 2(Spring) 1988, pp.29-34. Remember that all the essential reading for this programme is provided for you. Click the link (which may take you to the Online Library where you can search for a journal article) or click ‘next’ to go to the next page and start reading. Clark, P. ‘Chapter 3: Merger segmentation: an introduction’, adapted from Clark, P. and R.W. Mills Masterminding the deal: breakthroughs in M&A strategy and analysis (London: Kogan Page, 2013) © Pondbridge Ltd 2013. All rights reserved. The right of Peter J Clark and Roger W Mills to be identified as the authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Reproduced by permission of Kogan Page Ltd. 17.1 Clark Chapter 3: Merger segmentation: an introduction 17.1.1 Introduction: the compelling case for segmentation by merger type – precedent Differences between types of acquisitions may, however, be an important factor in determining which deals are likely to work… P. Pautler (2003) 13.[115] Intensified analysis of the causes and consequences of acquisition failure has produced knowledge about what can be done to make acquisitions succeed. This knowledge has been translated into new tools and techniques which may be applied to increase the chances of success... Clark, Beyond the Deal (1991) 7. Segmentation tends to produce depth of market position in the segments that are effectively defined and penetrated. W. Smith 1956, 5. Most Mergers Fail. That recurring headline in articles and research papers is widely-accepted today and substantially supported.[116] To most, MMF is reality, not merely “conventional wisdom.” But the great majority of restaurants fail,[117] but that doesn’t discourage entrepreneurs from dreaming up ideas for new bistros each season. Similarly, the urge to merge is irrepressible, continuing despite acquirers’ miserable past merger performance history viewed on a collective, historical basis. You might as well try to halt the ocean’s tide to stop as try to suppress gold rush-like enthusiasm next new merger wave, arising every ten years or so. So what explains the persistence of failed deal behavior despite wide acceptance of MMF? Some excuses include poor learning from past deal failures (Tuch and O’Sullivan 2007, 165) and acquiring company chief executive hubris (Morch et al. 1990, Roll 1986). Failure to anticipate cultural differences contributed to postmerger meltdowns at DaimlerChrysler, AOL TimeWarner and PennCentral. But a more fundamental explanation for merger misery is the historical absence of effective segmentation frameworks for evaluating, qualifying, and classifying candidate merger opportunities. Without such insight, acquisition-oriented operating companies are potential victims for every instant M&A fad imagined by merger pundits and brokers. Without a merger segmentation capability to serve as a sextant for its acquisition program, the acquirer’s M&A program is adrift. The start point to developing an answer to that question lies in the aspiring acquiring company’s development of its own merger segmentation framework. Some of characteristics of that resource are described in the rest of this chapter. 17.1.2 Merger segmentation dimensions, based on scholarly research ‘Long List’ of possible salient transaction & company characteristics for merger segmentation analysisNotes A: Corporate Key Contributors (Chapter 7); B: Agrawal, Jaffee and Mandelker; C: Diaz, Azofra and Gutierrez; D: Andrade, Mitchell and Stafford; E: Relating to Winner’s Remorse. Source: © Pondbridge Ltd. 2012-2013, all rights reserved. identifies seven dimensions of merger research into target company differences. That Table includes what is one of the best known M&A segmentation-related research papers, Coley & Reinton’s The Hunt for Value (1988). C&R’s two key points are summarised in Figure 3.1 C&R: Illustration of two merger segmentation dimensions which may significantly improve chances of M&A successSource: © Pondbridge Ltd. 2012-2013, all rights reserved. Based on data from Coley and Reinton, 1988, pp.29–30.. ‘Long List’ of possible salient transaction & company characteristics for merger segmentation analysis Notes A: Corporate Key Contributors (Chapter 7); B: Agrawal, Jaffee and Mandelker; C: Diaz, Azofra and Gutierrez; D: Andrade, Mitchell and Stafford; E: Relating to Winner’s Remorse. Source: © Pondbridge Ltd. 2012-2013, all rights reserved. Figure 3.1 C&R: Illustration of two merger segmentation dimensions which may significantly improve chances of M&A success Source: © Pondbridge Ltd. 2012-2013, all rights reserved. Based on data from Coley and Reinton, 1988, pp.29–30. Dimension: relatedness[118] There is also the possibility that diversifying into businesses that the acquiring firm has little expertise in can result in less efficient operations after the merger (reverse synergy). Lang and Stulz (1994) present evidence that firms that are in multiple businesses trade at a discount of between 5 and 10% on individual firm values and attribute this to a diversification discount. Damodaran (2005) 22. [119] Studies focusing on the type of acquisition find that… diversification tends to destroy value, whereas focus conserves it. Bouwman et al. (2003) 9–10. [120] The unrelated business tends to be at best incompletely understood by management at the acquiring company. A consequence is merger value destruction as an eager but under-informed buyer operates blindly. Azofra et al. (2007, 5) group business type diversification with geographic diversification (another dimension in ‘Long List’ of possible salient transaction & company characteristics for merger segmentation analysisNotes A: Corporate Key Contributors (Chapter 7); B: Agrawal, Jaffee and Mandelker; C: Diaz, Azofra and Gutierrez; D: Andrade, Mitchell and Stafford; E: Relating to Winner’s Remorse. Source: © Pondbridge Ltd. 2012-2013, all rights reserved.) as related threats to merger success: “M&A’s leading to diversification, be it geographically or by activity, tend to have worse results than those that lead to concentration (Houston et al. 2001; Marqueira et al. 1998).” Cyriac et al.’s Feb. 2012 analysis correlates the degree of diversification in the company’s basic business with returns.[121] Utilizing TRS (TSR, second-tier MergVal methodology today as described in preceding Chapter 2), the authors note an especially damaging characteristic of extreme diversification as shown in ‘Long List’ of possible salient transaction & company characteristics for merger segmentation analysisNotes A: Corporate Key Contributors (Chapter 7); B: Agrawal, Jaffee and Mandelker; C: Diaz, Azofra and Gutierrez; D: Andrade, Mitchell and Stafford; E: Relating to Winner’s Remorse. Source: © Pondbridge Ltd. 2012-2013, all rights reserved.: ceilings on achievable positive combined with possible significant chance of loss. The more focused the company, the more moderate those extremes. The authors’ TRS profile for what they refer to as “moderately diversified companies” is almost identical to that for “focused companies”. While limiting the firm to one SIC code likely stifles growth by providing insufficient scope for profit and value growth a two core company business structure still tends to be valued by the financial community as focused. Another important aspect of the relatedness dimension not considered by either Coley and Reinton or others considering the connection between relatedness and M&A success is whether the business model of acquirer and acquiree – how we make money – conflict.[122] This aspect of the relatedness dimension is considerably more elusive than mere differences in the business classification as defined by SIC code. Acquiring and acquiree (target) companies may share the same SIC code and yet be entirely different enterprises on a business model basis, reducing the prospects of merger success: ⦁ Airlines. On paper, it may make sense for the airline holding company to include both (a) a high volume discount fare airline division (in order to compete better with the industry leader, Southwest) in its company portfolio along with (b) traditional operators. But as British Airways[123] and some other traditional carriers have painfully learned, bolting on an airline with a completely different operating philosophy and cost structure often fails. ⦁ Consumer versus business banking. Tired of the extreme cyclicality of consumer banking, Citicorp actively sought acquisitions in corporate banking for years, before being acquired itself by Travelers. A successful consumer bank does not necessarily mean a successful investment bank, as Citigroup’s difficulties during Wave 3 (the subprime-derivatives bubble) attest. Other business model mis-combination examples include mergers stock brokerage and consumer retailing. (Henry, 2002)[124] And insurance: Carroll and Mui (2009, 17) describe Unum Insurance’s $5Bn. acquisition Provident Insurance in 1999 as another example of the importance of the business model considerations. Both firms were major providers of disability insurance, a surface similarity which encouraged some analysts to initially praise the combination. But those early observers did not look adequately at the critical differences in the two firms’ business models. But Unum sells only to corporations, whereas Provident sells only to individuals. That key difference impacts everything from sales approach and type of salesperson required to underwriting approaches and claims procedures. What was different in the acquirer’s and acquiree’s (target’s) business models? In a word, everything. Buying firm Unum was already aware of the threat of these business model differences to deal success from its own experience, as the acquiring firm in the Unum-Provident deal had previously tried to enter the individual part of the business but then quickly withdrew when that experiment failed. Dimension: relative size of intended merger partners The notion of relative revenue size differences between acquirer and target as a key consideration in merger segmentation originates from tactics for dealing with hostile acquisitions. Trimbath (2002, 45) observes: Several authors have reported size as a significant determinant of the probability of takeover. Singh (1975) suggested that, in theory, above a certain minimum industry adjusted size-class, all-firms can reduce the probability of acquisition… provided that they achieve a significant increase in their relative size. This idea was carried forward by Palepu (1986).[125] Particularly when and if the target and unwanted pursuer and target are both in the same or similar industry or segment (Relatedness, above), the possibility of regulatory opposition increases on the basis of perceived market control or unfair trade conditions. Azofra et al. (2007, 5) are among those who turn this negative (from acquirers’ perspective) into a positive by describing the advantages of pursuing target companies which are much smaller: “Those operations in which the size of the acquiring company is much greater than the acquired company’s also show greater returns.” When the acquiring firm is much larger than its prey, the envisioned result is improved focus on what the buying firm hopes to achieve from the merger. The target of manageable size and complexity is evaluated on a future expense and revenue basis by its buyer. Opportunities arise for the most promising improvements (synergies) to be carefully assessed, ideally resulting in a synergy-informed target bidding approach. Dimension: horizontal merger versus vertical merger A “horizontal” merger refers to two companies in the same part of the business while a “vertical” merger seeks to achieve vertical integration with the acquirer having all—or at least more—control of the commercial sequence from origination to delivery, such as Disney acquiring content developer Pixar. Tichy (2001, 347) reflects the dominant consensus about the relative attractiveness of the two different types when he says that, "Horizontal mergers fare best, especially if they are focus-increasing.”[126] Ingram et al. examine reasons underlying the sense that horizontal business combinations are more successful than vertical combinations. Horizontals are: "agreeable due to the belief that economies of scale and increased market power were unambiguously linked to superior performance." By contrast, vertical acquisitions are depicted by the authors in far less positive terms, as a means of avoiding "market failure”. (1992, 197)[127] Dimension: geography Azofra et al.’s (2007, 5) observation about geographic diversification (“M&A’s leading to diversification, be it geographically or by activity, tend to have worse results than those that lead to concentration.”) is indicative of investigation of this merger dimension as represented in ‘Long List’ of possible salient transaction & company characteristics for merger segmentation analysisNotes A: Corporate Key Contributors (Chapter 7); B: Agrawal, Jaffee and Mandelker; C: Diaz, Azofra and Gutierrez; D: Andrade, Mitchell and Stafford; E: Relating to Winner’s Remorse. Source: © Pondbridge Ltd. 2012-2013, all rights reserved.. Diaz, a co-author of the Azofra et al. paper, offers his own perspective in a separate paper two years later, referring to Houston and Ryngaert’s 1994 study: “Domestic M&As offer a greater potential for obtaining synergies derived, for example, from the elimination of redundant costs by geographical overlapping.”[128] A tendency to view a foreign market as appealing because some of the disadvantages of the more familiar home market appear to be missing may results in incomplete investigation of the overseas target. This is the greener grass error[129]: misdiagnosing foreign opportunities, not as a result of rigorous analysis of the target and its future prospect, but instead, because the foreign market is different from more familiar domestic areas of operation. NatWest’s 1995 acquisition of niche Manhattan investment bank Gleacher & Company was one of several merger missteps that contributed to NatWest’s loss of its independence. Royal Bank of Scotland (RBS) acquired NatWest in 1999.[130] Seeking to diversify into M&A advisory and gazing longingly across the pond at what management considered to be a less-regulated market with greater opportunities than the UK banking marketplace, NatWest (now part of RBS) was well positioned to succumb to the siren song of bankers about the well-shopped small bank, long known to be on trading block. NatWest management either failed to ask why trade acquirers in the US had deliberately rebuffed suggestions about Gleacher as an acquisition candidate for years, or didn’t care. A visible foreign acquisition in a new field always makes for adoring coverage in the financial press for a few days—or at least until that high ego deal unwinds. Idiosyncratic Gleacher was a challenging enough acquisition for a PMI implementation-oriented, tough-minded buyer, which NatWest was not. The triple shocks of discovering that (a) Gleacher had already become a marginal player in the movement towards megabanks, (b) limitations of the US investment banking environment were at least as oppressive as British regulations and perhaps more so because of more active and effective regulators, and (c) that NatWest’s experience was irrelevant to effective management of Gleacher, led to rapid retreat and to neglect of NatWest’s base business and operations in the UK. Dimension: overpayment by acquirer The relationship between overpayment and merger success is examined in part of Chapter 2 on prevailing MergVal methodology: Value Gap. Two separate studies suggest that most mergers fail when the Acquisition Purchase Premium (APP) exceeds 37-38%. That M&A failure rates increase when bid pricing has scant connection to synergy diagnosis for that specific deal is commented upon by several researchers. Dimension: phase timing in the merger wave The pattern of merger waves is addressed in the first edition of Beyond the Deal in pages 25-28 and 50-54 and also in this edition in several parts of the first chapter. Two of the three alternative outcomes for the 1982-1990 LBO boom as reflected in Figure 2.2 from the 1991 book (52) anticipated collapsing conditions. Rhodes-Kropf and & Viswananthan (2004) perceived late phase deals as increasing the prospect of merger value destruction as eager acquirers overestimate synergies in late periods in order to meet the heightened APP requirement of sellers as the business-merger wave approaches collapse. 17.1.3 Nine merger types: different deal types mean different levels of merger success The market is skeptical about M&A, but it is more receptive to some kinds of deals than to others. Bieshaar et al. 2001, 65[132] The illustrative success ranges shown in the exhibit presume middle-of-merger-wave timing and median purchase premiums for that phase, industry and type of merger. Adjustments to those assumptions are addressed in the following part in this chapter, Applying the Nine Merger Type Framework. The rank order starts with the most assured type of deal (Bottom Trawler at 87–92% success probability) at the top of the list. Highly speculative so-called transformational deals which promise to change everything (but with 20% or less estimated success probability) are shown at the bottom of the list in Nine Merger Types, Related Est. Success Probability RangesSuccess probability ranges for each of the nine types in Table 3.2 are preliminary, based on several research analyses believed to be indicative of success performance under mid-cycle, average purchase premium circumstances. Both the upper and lower ends of the estimated model success ranges are continually being reviewed, and are subject to change. This exhibits version 2 of that ongoing analysis, and is related to M-Score development (part 4 in this chapter). In Table 3.2, Coty/Avon was pending at the time of exhibit development but the two companies later terminated their merger discussions.Categories: 1 Opportunistic / 2 Operational / 3 Transitional / 4 Transformational *Excluding last standing participantSource: © Pondbridge Ltd. 2012-2013, all rights reserved.. Nine Merger Types, Related Est. Success Probability Ranges[133] Categories: 1 Opportunistic / 2 Operational / 3 Transitional / 4 Transformational *Excluding last standing participant Source: © Pondbridge Ltd. 2012-2013, all rights reserved. 1 Bottom Trawlers (87-92% deal success probability range (est.)) Our basic formula was to look for companies (often troubled ones) with growth potential, offer to pay more for them than they were worth, and then fix them. Former ITT CEO Harold Geneen (1997) 32.[134] “Trawlers” refers to the mindset of bargain-seeking acquirers; “bottom” to the status of their prospective targets. The bottom trawler acquirer searches the depths of the available companies lists, actively seeking companies in distress which have recently declared We can no longer compete (Circuit City and Palm in the ‘00s), or comparable. The reasoning: a company which is available at a minimal price and APP faces minimal risk of failure because little is at risk. Even if the deal fails completely, proceeds from liquidation are a higher percentage of the purchase price paid than for the other eight types of acquisitions. However, in the bottom trawler type of transaction, the number of bidders and bid cycles are minimal, thus suppressing the purchase premium (AMS 2001, 106). Facing threats to its economic viability, the bottom trawler target’s extreme requirement for immediate funds limits preferred bids to all all-cash offers, reducing the number of bidder further. If the company has formally declared that it can no longer compete (UK Woolworths), the APP may slip to zero or even less. Projected synergies for the bottom trawler target decline with any delays to the sale date. There is already a freeze on all new financing and hiring to preserve cash, while other assets and standalone operations are sold off just to raise survival cash for the parts of the company that remain. Those e- (expense) synergies which vary in accordance with unit volume levels decline further (Figure 4.3), as company growth stagnates. The target company is imploding, and r- (revenue) synergies are non-existent. With these reductions in both synergy types and also and the APP, the opportunity may emerge for a reduced Value Gap lower bid for the bottom trawler company, as depicted in the exhibit. One such bottom trawler collapse was Marconi, which failed because reliance on a single account, British Telecommunications. When BT awarded a major contract to a Marconi rival, the remnant of what was once the Hanson conglomerate dissolved. The surviving pieces were absorbed by Ericsson at bargain levels in 2005.[135] But if the acquirer overbids, the low APP appeal of the bottom trawler deal to the bargain-hunting acquirer is lost. Five years late to market with its PreTMbrand smartphone, Palm management declared We cannot compete shortly afterwards. Hewlett-Packard outbid another suitor and paid $2.1Bn in January 2011 for a business which was effectively written off one year later. 2A Bolt-Ons (80-85% success profile) As the name implies, “Bolt-Ons” imply a target business which fits seamlessly into the acquirer’s existing product-service range. A publisher adds a new title in a fast-growing but presently uncovered related segment. A catalogue company that specializes in plus size specialty dresses for women acquires a company which concentrates on clothing designed plus-size male counterparts. Bolt-Ons are assigned a success expectation that is only slightly less than that of Bottom Trawlers. Acquisition of Tropicana® by PepsiCo or Procter & Gamble’s purchase of Pantene are as examples. In both instances, the acquiring company was already deeply familiar with both the category and the product, having been involved in somewhat similar products in the past. Risks associated with Bolt-Ons are minimal and manageable. Some legacy customers of the target might fear the acquired brand will lose its quality and/or exclusivity. But that risk can be mitigated by careful formulation marketing and channel management and generally does not represent a major obstacle to deal success. While the original ‘with pulp’ Tropicana orange juice used to command just one product-width in the grocer’s chilled juices section, today’s spin-offs – withoutpulp, combined with other juices, on and on – multiply PepsiCo’s selling space in that high velocity, higher profit part of grocery stores. A related advantage is that Tropicana’s expanded footprint also indirectly reduces the space available for competing products. Pantene, the upmarket hair products company acquired by P&G, has been transformed from an exclusive, almost non-advertised (except in print) salon-grade producer, to something slightly more down-market, supported by new advertising and different pricing. Post-acquisition, the abandonment of some snob appeal was more than compensated for on the acquirer’s bottom line. 2B Line Extension Equivalents (65-70% success profile) Similar to but slightly below the Bolt-On deals in terms of success probability profile are Product-Service Line Extension Equivalents. The illustrative example listed Nine Merger Types, Related Est. Success Probability RangesSuccess probability ranges for each of the nine types in Table 3.2 are preliminary, based on several research analyses believed to be indicative of success performance under mid-cycle, average purchase premium circumstances. Both the upper and lower ends of the estimated model success ranges are continually being reviewed, and are subject to change. This exhibits version 2 of that ongoing analysis, and is related to M-Score development (part 4 in this chapter). In Table 3.2, Coty/Avon was pending at the time of exhibit development but the two companies later terminated their merger discussions.Categories: 1 Opportunistic / 2 Operational / 3 Transitional / 4 Transformational *Excluding last standing participantSource: © Pondbridge Ltd. 2012-2013, all rights reserved. is Volkswagen’s acquisition of Eastern European automaker Skoda. By acquiring that nameplate, the parent lowered production costs in two ways: (a) through access to new labor markets and by (b) increasing scale economies for VW’s existing product platforms. Marketing-wise, the move broadened VW’s appeal into lower-price segments without repositioning the parent nameplate. The direction (upmarket or downmarket) of the line item extension equivalent is sometimes a factor in that merger’s success or failure. When an upmarket nameplate diversifies with a downmarket target, both acquirer and acquiree face potential damage to their respective commercial franchises. The downmarket company moving upwards face the possibility of losing its traditional accounts, as low-end market rivals ignite the flames of customers' fears that extra overhead mean the end of the value-for-money positioning (cheap, compared to most everyone else). When the upmarket brand is perceived as moving downmarket by merger, that sense of exclusivity can rarely if ever be recaptured. 3A Consolidation Mature (55-60% success profile) The prospective acquiring company’s industry is mature: stable and mid-life in terms of corporate economic life span (Mauboussin-Johnson’s CAP). The sector’s rate of profit growth has flattened, with speculation that the rate of increase will soon begin to decrease. Unit (volume) growth has also recently plateaued, although revenue growth may temporarily still be increasing because of aggressive pricing. New pockets of excess capacity arise every year because of new, low-cost entrants and too many legacy competitors. From personal computers to pharmaceuticals, steel fabrication to logistics, the unwritten role is either buy or be acquired. [136] In this contraction form of consolidation merger, there is mutual understanding by primary participants in the industry the future value strategy for survivors has changed from offensive (revenue-propelled) to defensive, or expense-based, primarily in the form of scale efficiencies and rationalization of overlapping costs, the two most reliable expense synergies. The fastest way to bring costs closer in line with capacity is also the oldest technique: plant shutdowns. Akdogu et al. (2009, 9) observe that: “Maksimovic et al. (2008) show that, for mergers in manufacturing industries, the acquirer on average closes or sells about half of the target firm’s plants.”[137] The asterisk in Nine Merger Types, Related Est. Success Probability RangesSuccess probability ranges for each of the nine types in Table 3.2 are preliminary, based on several research analyses believed to be indicative of success performance under mid-cycle, average purchase premium circumstances. Both the upper and lower ends of the estimated model success ranges are continually being reviewed, and are subject to change. This exhibits version 2 of that ongoing analysis, and is related to M-Score development (part 4 in this chapter). In Table 3.2, Coty/Avon was pending at the time of exhibit development but the two companies later terminated their merger discussions.Categories: 1 Opportunistic / 2 Operational / 3 Transitional / 4 Transformational *Excluding last standing participantSource: © Pondbridge Ltd. 2012-2013, all rights reserved. next to this merger segmentation type arises because of what is referred to in this chapter as the Last Man Standing situation. For both acquirer and acquiree, the consolidation march continues until the sector becomes so concentrated that eventually there are only one or two independent companies (that is, not members of the one or two consolidation groups) still remaining. In segments from stock brokerage to reinsurance, grocery chains to department stores, a consolidation pattern emerges. Avoiding a deal during the industry’s initial consolidation period may be advantages to both acquirer and target: the careful buyer is able to learn from the mistakes of less patient acquirers, and sometimes pick up some attractive divested niche businesses that must be divested as a result of that first series of deals. For the target, higher prices (APPs) are the reward for patience, as the remaining acquirers sense that their window of opportunity is closing, and are motivated to act. 2C Multiple Core Related Complementary (40-45% success profile) Whilst the business media tends to concentrate on the product similarities between acquirer and target, this combination involves a greater integration challenge than the Line Extension Equivalents (60-65%) in Type 2B. The greater depth and complexity of the acquisition type leads to a lower success profile. The acquiring company likely struggled with that portion of its strategy in the past: P&G/Gillette is an example of a combination of this type that appears to be prospering; AT&T’s multiple acquisitions aimed at accelerating entry into the computer business in the late 1980s and early 1990s indicate the opposite: ⦁ P&G’s interest in men’s toiletries was manifested years before the Gillette deal in the form of the acquisition of Shulton, which failed to advance the acquirer’s goals in that segment when the primary salvageable nameplate turned out to be the venerable Old SpiceTM brand. Acquisition of Gillette provided P&G with an instantly recognizable name and also a platform for future product growth in that field. ⦁ AT&T’s multiple attempts at establishing a new core competency in computers first concentrated on internal developments and then Olivetti and NCR, the former National Cash Register. Eager to make up for lost time after the disappointing commercial relationship with Olivetti, AT&T overpaid for UK’s NCR in 1990. That second acquisition also ended in ruin, based upon Value Gap methodology in Chapter 2: AT&T lost about half of its $1Bn. purchase price over four years, before divesting the company in 1994. The combination of high APP combined with minimal synergies (in part because of AT&T’s laissez faire postmerger approach in the first years after the close) assured deal failure as measured a Value Gap (APP-NRS) basis. 3B Consolidation – Emerging (37–42% success profile) A merger implementing a new technological innovation may, as the news of the innovation spreads, induce follow-on takeovers among industry rivals for these to remain competitive. B.E. Eckbo (2010) 123[138] The second of the two consolidation merger types (the first being 3A, Consolidation Mature) faces a noticeably lower success profile, in part because neither principal to the deal is yet fully established. At first, the two rivals in the same fast-growing segment insist that they will go it alone. At some point in time, it becomes apparent that there are more companies than customers and that actions must be taken to ensure that the firm is one of the survivors. The unthinkable becomes thinkable: combining with your rival with the objective of emerging as the one giant in the sector. As with the first Dot-Com bubble more than a decade earlier (Clark 2000, 201-207) commercial and financial markets are both seeking to distinguish market leader from chronic laggard as the new concept sector evolves and emerges. Almost any entrant can make an initial splash; but as the financial support critical to future growth tends to flow first and most to those firm’s perceived as survivors, a defendable market share and customer offer is mandatory, even if it means sacrificing company independence. Two factors account for the lower success profile compared to Type 3A, Consolidation Mature. The first is reserves. Business models of companies in emerging industries are often unstable, with consistent profitability yet to be established. In 2011-2012, surprise quarterly losses by several of the new publicly-traded social networking (SN) companies indicate that challenges with subscriber churn, advertising approaches, expense management and sometimes, regulation persist. Despite being proclaimed as the next great thing, margins for error are limited. A second factor is management. Only a few years from their start-up dates, emerging companies are more likely to be run by entrepreneurs who are great at starting companies, but not so great at building them into major, consistently profitable corporations. 2D Single Core Related Complementary (30-35% success profile) This merger type is comprised of deals that are similar to the other type in the Transitional Category (2C, Multiple Core Related Complementary) except that the target business has only a tenuous connection to the acquirer’s base business, and thus limited synergy opportunities. Combinations such as eBay/PayPal fall into the 30-35% success envelope; DaimlerChrysler and H-P/Autonomy are indicative of the mirror 65%-70% failure probability. 4A Lynchpin Strategic (20-25% success profile) What’s a company to do when its primary business is rapidly disappearing? Assuming that neither selling out nor liquidation are best for shareholders in value creation terms, the company’s priority is to capture a supplemental core business quickly in an attempt to elude implosion.[139] Lynchpin Strategic’s 20-25% success profile is only slightly more optimistic than outright speculative acquisition bets as represented by 4B, Speculative Strategic (15-20%). Both of these two M&A types comprising the Transformational category involve major changes in the acquiring firm’s future direction: ⦁ The business of the prospective target is mostly to completely unfamiliar, relegating the buyer to similar role comparable to that of the detached financial takeover company acquirer. Little or no new expertise is brought to bear on either day-to-day or strategic management of the target company. The notion that new incentives might encourage holdover management in the target firm to increase firm value persists among such acquirers; but a change in company ownership is not necessarily required for such improved performance.[⦁ 140] ⦁ Eager to avoid implosion, negotiating leverage is lost and the seller knows it. Especially if the target is well-managed already, the adverse Value Gap between purchase premium paid and achievable synergies means a deal with minimal chances of success.[⦁ 141] ⦁ Success chances are reduced by the additional layers of managers in the acquired firm who must be educated continually about the company that they are nominally managing. At the very least, bringing the acquiring company’s management ‘up to speed’ reduces performance in the acquired firm (one example: AOL’s acquisition of TimeWarner). In chronic situations, top talent departs from the acquired firm, frustrated at inconsistent management by administrators perceived as outsiders. That the tactic sometimes works—such as in IBM's dramatic turnaround under then-CEO Louis Gerstner in the 1990s—argues against combining this merger type with the lower probability 4B type in Nine Merger Types, Related Est. Success Probability RangesSuccess probability ranges for each of the nine types in Table 3.2 are preliminary, based on several research analyses believed to be indicative of success performance under mid-cycle, average purchase premium circumstances. Both the upper and lower ends of the estimated model success ranges are continually being reviewed, and are subject to change. This exhibits version 2 of that ongoing analysis, and is related to M-Score development (part 4 in this chapter). In Table 3.2, Coty/Avon was pending at the time of exhibit development but the two companies later terminated their merger discussions.Categories: 1 Opportunistic / 2 Operational / 3 Transitional / 4 Transformational *Excluding last standing participantSource: © Pondbridge Ltd. 2012-2013, all rights reserved., despite Gerstner-IBM example probably being an exceptional instance. 4B Speculative Strategic (15-20% success profile) Speculative strategic deals secure a well-deserved bottom rung in the nine merger type list with minimal profile success (15-20%). Driven by desperation and/or enticed by the siren song of a dramatic, visionary ego-acquisition, these stillborn M&A deals are easily spotted: consider the merger success dimensions identified in ‘Long List’ of possible salient transaction & company characteristics for merger segmentation analysisNotes A: Corporate Key Contributors (Chapter 7); B: Agrawal, Jaffee and Mandelker; C: Diaz, Azofra and Gutierrez; D: Andrade, Mitchell and Stafford; E: Relating to Winner’s Remorse. Source: © Pondbridge Ltd. 2012-2013, all rights reserved., and such transactions are almost always on the adverse side of each variable, sometimes all of them. In the last thirty years, similar transactions prompting a collective financial market response of Is this a joke? have included the aforementioned NatWest/Gleacher deal, Coca Cola’s purchase of film producer Columbia Pictures, AOL/TimeWarner, eBay/Skype, and nearly every deal attempted by former Vivendi Universal chief executive officer Jean-Marie Messier. 17.1.4 Other merger segmentation considerations Considerations such as timing, relative size, relative Acquisition Purchase Premium and geography all potentially modify the model success probabilities by type as identified in Nine Merger Types, Related Est. Success Probability RangesSuccess probability ranges for each of the nine types in Table 3.2 are preliminary, based on several research analyses believed to be indicative of success performance under mid-cycle, average purchase premium circumstances. Both the upper and lower ends of the estimated model success ranges are continually being reviewed, and are subject to change. This exhibits version 2 of that ongoing analysis, and is related to M-Score development (part 4 in this chapter). In Table 3.2, Coty/Avon was pending at the time of exhibit development but the two companies later terminated their merger discussions.Categories: 1 Opportunistic / 2 Operational / 3 Transitional / 4 Transformational *Excluding last standing participantSource: © Pondbridge Ltd. 2012-2013, all rights reserved.. Several preliminary adjustments are identified in Four Adjustments to Table 3.2’s Nine Merger Segmentation ArchetypesPercentages are adjustments to the model success percentages shown in Table 3.2; for example, a ten percent downward adjustment in a Type 2A Line Extension Equivalents success probability of 80% indicates a reduction to 72%. Weights sum to 95 rather than 100 because of other factors including but not limited to: culture, first-time CEO of major corporation within first three years in office, rapid obsolescence of company technology. Source: © Pondbridge Ltd. 2012-2013, all rights reserved., along with the possible effect on profile success probability ranges. Four Adjustments to Table 3.2’s Nine Merger Segmentation Archetypes Percentages are adjustments to the model success percentages shown in Table 3.2; for example, a ten percent downward adjustment in a Type 2A Line Extension Equivalents success probability of 80% indicates a reduction to 72%. Weights sum to 95 rather than 100 because of other factors including but not limited to: culture, first-time CEO of major corporation within first three years in office, rapid obsolescence of company technology. Source: © Pondbridge Ltd. 2012-2013, all rights reserved. Timing: phase of the merger wave APP percentages: level, trend, in relation to synergies The model success percentages shown in Nine Merger Types, Related Est. Success Probability RangesSuccess probability ranges for each of the nine types in Table 3.2 are preliminary, based on several research analyses believed to be indicative of success performance under mid-cycle, average purchase premium circumstances. Both the upper and lower ends of the estimated model success ranges are continually being reviewed, and are subject to change. This exhibits version 2 of that ongoing analysis, and is related to M-Score development (part 4 in this chapter). In Table 3.2, Coty/Avon was pending at the time of exhibit development but the two companies later terminated their merger discussions.Categories: 1 Opportunistic / 2 Operational / 3 Transitional / 4 Transformational *Excluding last standing participantSource: © Pondbridge Ltd. 2012-2013, all rights reserved. presume a transaction that is closed around mid-point in the merger wave, approximately at the end of Phase II and the beginning of Phase III (of four). Deal success indirectly coincide with the timing of the transaction over the merger cycle, with higher success in earlier merger wave phases because of (a) lower relative Acquisition Purchase Premium ranges in percentage terms, and (b) a more advantageous relationship between synergies and acquisition premiums. Figure 2.5 in the preceding chapter (“Considering Both Value Gap Determining Factors, Over the Business-Merger Cycle”) depict reasons why deals consummated in the early phases of the business-merger cycle tend to exhibit greater success than deals closed late in the wave. If early phase transactions tend to be lower risk but sometimes challenging to finance, transactions which occurring much later in the wave but prior to that bubble’s exhaustion peak[143] (for purposes here, mid Phase III to mid Phase IV) show the opposite characteristics: straightforward to finance but with treacherously high APPs and TAPPs (Appendix A), which threaten the all viability of deals closed then. As noted in the preceding chapter, merger success based on the Value Gap criteria is not just a matter of high Acquisition Purchase Premiums but also high APPs relative to Net Realizable Synergies (NRSs). Late in the merger cycle, the combination of high APPs and unchanging (flat) Met Realizable Synergies (NRSs) means a widening Value Gap, indicating a possible failed acquisition. That exhibit is illustrative and shows relative APP-to-NRS percentages. The exact Value Gap is determined on an individual company basis, thus affirming the importance of in-depth knowledge of available synergies. That said, this book suggests that achievement of Net Realizable Synergies of more than 30-38% (on a basis comparable to APP percentages) is unusual. In a Financial Times’ article by Daniel Schaefer dated Dec. 10-11 2011 entitled “Quarter of US Buy-Outs in Bubble Years Remain at Risk” focuses on the performance of mergers consummated during the hectic final two years of the 2002-2008 subprime business-merger cycle. The overview of that Moody’s report on the performance of 40 large, late phase acquisition at the end of Post-1980 Wave 3 concludes that: “Many of the large, bubble-era LBOs… have had weak revenue growth and high default rates… since their LBO closings… It may be difficult for private equity investors in lower-rated LBOs to realize returns on their initial investment”.[144] Domestic versus international Diaz et al.’s (2009, 15) perspective on the potential negative effects of geographic diversification on merger success are noted in conjunction with ‘Long List’ of possible salient transaction & company characteristics for merger segmentation analysisNotes A: Corporate Key Contributors (Chapter 7); B: Agrawal, Jaffee and Mandelker; C: Diaz, Azofra and Gutierrez; D: Andrade, Mitchell and Stafford; E: Relating to Winner’s Remorse. Source: © Pondbridge Ltd. 2012-2013, all rights reserved.. The issue-behind-the-issue is control. When the target’s headquarters and principal operations are located near to those the acquirer’s HQ, candidate synergies can be more easily diagnosed and monitored than compared to when operations are separated by thousands of miles. A target based in a different continent than the acquirer also presents possible extra obstacles in the form of communications, logistics, and sometimes, currency transfer. Thus it is no surprise when the new acquiree’s headquarters and main operations centers are ‘brought home’ to the acquirer’s headquarters location: SBC/AT&T, BMC/Harris, BT/Dialcom, General Dynamics/multiple targets. Distant headquarters locations may be a contributing factor in other potential success-reducing factors, including conflicting business models, control/ownership structures and cultures. Regarding the latter, a private Middle Eastern bank’s decision to pursue a merger with another institution based in a different country faced new integration challenges, including but not limited to: transaction (different languages), new regulatory environment, and differing working styles and work ethics. Topic summary Identifying and defining the characteristics that make some merger deals successful and others a failure is not easy. We find that some companies, despite having high probabilities of success, end up not being able to realise the projected synergies in the expected time, while others with lower success probabilities end up succeeding. Nevertheless there are a few clear actions (or lack of them) that help improve the ratio of success. As you saw in the Coley and Reinton reading, failure in US M&A deals is more common than in the UK, where half the deals are successful, and 16% of the M&A deals studied in this report are not able to define whether the deal was a success or a failure. Some of the key mistakes identified are paying too much (this brings us back to the APP question, studied in a previous topic), making rosy estimates (over-optimism and excitement from the management team making the projections of cash flows) and poor integration processes. The same article gives us some tips that really worked to make merger deals successful. By now you will be able to consider all of them: ⦁ reorganising costs to make the acquisition more profitable ⦁ identifying the assets that create additional value, and selling others ⦁ carefully managing the integration process – including taking care of customers and employees, paying attention to customer service and to product/service quality during the process. Let us not forget that companies exist because of their customers and employees (key resources) and sometimes, in the fuss of the integration, they are not considered until last! Further reading These readings can deepen your understanding in key areas of importance covered in this topic, but are suggested rather required. You should therefore read them only if you have time. ⦁ Badrtalei, J. and D.L. Bates ⦁ ‘Effect of organizational culture on mergers and acquisitions: the case of DaimlerChrysler’, International Journal of Management 24(2) 2007, pp.303–17. ⦁ Bieshaar, H., J. Knight and A. Van Wassenaer ⦁ ‘Deals that create value’, The McKinsey Quarterly 1(Winter) 2001, pp.64–73. ⦁ Rehm, W., R. Uhlaner and A. West ‘Taking a longer-term look at M&A value creation’,⦁ ‘Taking⦁ a longer-term look at ⦁ M⦁ &⦁ A⦁ value ⦁ creation’,McKinsey&Company January 2012. ⦁ Tichy, G. ⦁ ‘What do we know about success and failure of mergers?⦁ ’, Journal of Industry, Competition and Trade 1(4) 2001, pp.347–94. 17.1 Understand the impact on merger valuation success of differences between the acquirer and target in terms of (a) relative size and (b) truerelatedness. Date 17.2 Comprehend how consolidation (the combination of former competitors) comprises the primary form of business merger in both present and past M&A waves. 17.3 Understand why dynamism – such as entering unknown countries or embracing new concepts, approaches, or technologies – often reduces rather than increases the probability of merger success. Topic 18 : Emerging M&A – selected issues Introduction Most M&A scholars, practitioners, and analysts in finance and merger strategy have largely based their studies on cases in developed countries, and the emerging-market context remains under-explored. In the last two decades, the world has witnessed a dramatic economic shift from developed economies to emerging-market economies, thanks to the globalisation and economic reforms initiated by emerging-market countries. This topic seeks to provide you with an introductory look at some of the issues and challenges facing countries with developing financial markets (and their buying companies), for which M&A represents a path to accelerating growth. Topic 18 and the following Topic 19 are closely related and yet distinct. While Topic 18 focuses on general analysis of emerging M&A approaches and motivations, Topic 19 will examine specific tactics and decision factors in both of the surging merger giants in the Far East: China and Japan (although note that the latter is never included in the ‘emerging’ classification and is restricted to Topic 19 only). Over the past decade, emerging markets have enjoyed huge economic success. By 2010, emerging market economies (taken together) accounted for 40% of the world‘s global output, as opposed to only half that figure (20%) in 1990. Moreover, the number of M&A activities by emerging-market firms has rapidly increased to exploit growing markets at home and abroad. This remarkable growth in emerging markets has a huge impact on the global economy. As economies get wealthier, their institutional environment and the depth of their capital markets improve and emerging-market firms become more global. Most emerging-market firms are frequently reforming their corporate strategies to keep up with the increasing pace of change in the global financial arena. Strategies that worked in the beginning of the 2000s may not be right in the current time, and will not be right for the next 15 years. Thus, a clear and well-understood strategy is vital for these emerging market firms to better compete not just with their developed world counterparts but even at home, and to become successful in their corporate activities. There is a clear link between initial public offerings (IPOs) and M&A deals. To be able to complete these types of deals, companies need to operate within a sophisticated capital market that is efficient and transparent. According to Thomson Reuters, in 2014 alone M&A deals in the USA climbed by 51.4% to $1.53 trillion and the Asia Pacific region hit its largest ever total at $716 billion. During the same period, 145 deals closed in Hong Kong representing a 113% increase year to year (YTY), which helped companies raise $25 billion in capital. It is important to mention that the first day average return on these deals in Hong Kong was 2.9% and 37% in Shanghai and Shenzhen for 2014. These numbers have been increasing over time, hand in hand with China’s development of its financial market and increasing openness. May 2016 saw the first issue in London of bonds in the local currency, the Yuan, which is another signal of Chinese financial markets’ increasing openness and interest in becoming more international. This pattern is shown in M&A deals with an increasing number of cross-border deals. ‘China Inc.’ is the term we will use throughout this topic to refer to private or non-state Chinese companies affected by this change, viewed as a group. However, such cross-border influences apply to state-dominated firms in China as well. Essential reading Read the essential readings for this topic and then develop your responses to the quiz and self-assessment questions that follow. Cogman, D., P. Jaslowitzer and M.S. Rapp ‘Why emerging-market companies acquire abroad’, McKinsey&Co. July 2015. Willers, Y-P., D. Lee, Y. Luo, S. Yuan and V. Yang ‘Gearing up for the new era of China’s outbound M&A’, The Boston Consulting Group 24 September 2015. Romei, V. ‘Chinese appetite for foreign technology companies could be good news for everyone’, FT.com November 2015. Lebedev, S., M.W. Peng and E.S. Stevens ‘Mergers and acquisitions in and out of emerging economies’, Journal of World Business50(4) 2015, pp.651–62. Remember that all the essential reading for this programme is provided for you. Click the link (which may take you to the Online Library where you can search for a journal article) or click ‘next’ to go to the next page and start reading. Topic summary In this topic we have seen that M&A deals from countries such as Japan and China have been increasing in recent years. For China, this is true for the outbound but not so much for the inbound. Foreign companies planning to get into M&A deals with local companies face a handful of issues, especially related to obtaining regulatory approval and during the post-merger integration process, which can be opaque and difficult without having personal connections. Japan is another story. Mitsubishi UFJ Financial Group (MUFG), which is Japan’s largest bank, made the news in 2016 by announcing its intention to become a global power through acquisitions. Coming from an M&A boom in 2015, Japan’s main markets today are Indonesia and the United States. The reasons to fly overseas are an ageing population and a shrinking domestic market, with the added motivation of available, inexpensive borrowing. To refer back to the APP issue mentioned in previous topics, Japan paid more than 46% premium on average for their acquisitions abroad in 2015. As in China, inbound deals in Japan are not meeting the OECD (Organization for Economic Cooperation and Development) average of 32%, being only at 3.5% despite the Japanese Prime Minister’s efforts to increase FDI (foreign direct investment). 18.1 Understand and describe the principal driving forces in emerging-market M&A deals. Date 18.2 Understand why many firms based in emerging markets proceed with M&A programmes, and describe the outcomes. 18.3 Understand some of the more important cross-border influences growing China’s international role as one of the top-tier M&A powers of the future.