Mergers & Acquisitions: The Good, The Bad, And The Ugly (And How To Tell Them Apart) by S&P Global Market Intelligence
by Richard Tortoriello; Temi Oyeniyi, CFA; David Pope, CFA; Paul Fruin, CFA & Ruben Falk
Year-to-date through July, over $800 billion of merger-and-acquisition (M&A) activity has been announced in the U.S. Should acquiring-company shareholders expect to benefit? In this study we show that, among Russell 3000 firms with acquisitions greater than 5% of acquirer enterprise value, post-M&A acquirer returns have underperformed peers in general. A number of deal-related and fundamental attributes can be used to separate the ‘good’ from the ‘bad’ (and, sometimes, the really ugly).
- Despite the often-heard claim of M&A synergies, acquirers lag industry peers on a variety of fundamental metrics for an extended period following an acquisition. Profit margins, earnings growth, and return on capital all decline relative to peers, while interest expense rises, as debt soars, and other “special charges” increase.
- Stock deals significantly underperform cash deals. Acquirers using the highest percentage of stock underperform industry peers by 3.3% one year post-close and by 8.1% after three years. Also, acquirers with the highest one-year cumulative M&A spending1 underperform by 2.0% one year post-close and by 9.3% after three years.
- Acquirers that grow quickly pre-acquisition often underperform post-acquisition. Acquirers with the highest pre-acquisition asset growth, underperform by 5.8% one year post-close and by 13.3% after three years, while those with the highest preacquisition increase in shares outstanding also underperform significantly.
- Finally, we show that excess cash on the balance sheet is detrimental for M&A, possibly due to a lack of discipline in deploying that cash. Acquirers with the highest level of pre-acquisition cash & equivalents relative to assets underperform peers by 8.6% over one year and 10.1% over three years.
- We look at M&A factors and returns using both an event study and a regression approach and conclude with a simple multi-factor strategy for differentiating good from bad deals in the aggregate.
The academic literature on M&A is vast but comes to few definitive conclusions. Although nearly all studies agree that M&A creates value for target-company shareholders, studies on post-M&A results for acquirers have no such unanimity.
This disparity is due to a simple truth: target company shareholders almost always receive a takeover premium. However, post-M&A acquirer returns depend on fundamental performance, which is affected by many factors, including deal size, due diligence adequacy, corporate culture, deal structure, valuation, funding sources, and management experience. Although post-close M&A research results are mixed, we’d cite a few relevant studies:
- Agrawal et al (1992) find stockholders of acquiring firms suffer a statistically significant loss of about 10% over the five-year post-merger period.
- Rau and Vermaelen (1998) show that stock mergers underperform while cash/tender offers outperform in the three years following an acquisition.
- Jensen and Ruback (1983) remark: “These post-outcome negative abnormal returns [in the year following a merger] are unsettling because they are inconsistent with market efficiency and suggest that stock price changes during takeovers overestimate . . . future efficiency gains.”
- Lang et al (1991) find that acquirers with excess cash flow tend to overbid for targets, while Jensen (1986) suggests a tendency toward empire building among cash-rich firms.
- Mortal and Schill (2015) show that the poor post-deal returns for stock acquisitions are explained by return effects associated with larger asset growth rates for stock versus cash deals.
Our findings confirm many of the results cited above and, in addition, suggest that preacquisition growth rates in assets and shares outstanding are associated with post-M&A acquirer returns. We also show that poor post-acquisition stock performance directly reflects deteriorating post-acquisition fundamentals in terms of profitability, return on capital, and earnings growth.
Figure 2 shows U.S. and Canada completed M&A activity by gross transaction value over the past 18 years. Note that 2015 represented a new peak in terms of transaction values and that with the exception of 1998 to 2000 most transactions have been cash transactions, although stock transactions have picked up in value as of late.
2. What Causes Acquirer Post-Acquisition Underperformance?
Acquisitions may be pursued for a variety of reasons: to revive stagnant revenue growth, enter a new market, gain new products/technologies/talent, reduce competition, etc. However, a key premise of any acquisition is that “the whole will be greater than the sum of the parts.” 2 While acquiring-company management almost universally tout expected “synergies” and efficiency gains, our research shows that, on average, such synergies either do not exist or are only realized over an extended time horizon (i.e., well over three years).
Within the Russell 3000, M&A transactions can be summed up quite neatly: in aggregate, acquirers tend to underperform peers for an extended period following a significantlysized acquisition (section 2.1). We see the underlying cause for this underperformance in deterioration in post-acquisition fundamentals. Section 2.2 shows that a number of key fundamental ratios weaken following significant M&A activity.
2.1 Acquirer Pre- and Post-Acquisition Returns
Figure 3 shows M&A industry- and universe-relative3 acquirer returns for the Russell 3000 that closed between 2001 and 2013, measured from one year pre-close to three years postclose. Median returns are consistently negative, signaling universe/industry underperformance, and hit rates 4 are low and downward trending. (Although we present statistics going out three years, underperformance continues for at least five years.)
Note that by the third year following an acquisition only about 40% of acquirers have outperformed their industry- or universe-relative benchmarks. Pre-close market caps are in line with industry means and post-close market caps only modestly higher, so market cap effects (the so-called “size effect”) on performance are likely minimal. All returns and hit rates are significant at the one percent level.
2.2 Acquirer Pre- and Post-acquisition Fundamentals
Despite the oft-heard claim of potential M&A synergies, acquirers lag peers on a variety of metrics for an extended period following an acquisition. The graphs in this section display the industry-relative median values for the Russell 3000 M&A universe with close dates from 2001 to 2013.
Figure 4 shows that profit margins (left chart) fall below the industry median following an acquisition. Net margins deteriorate more than operating (EBIT) margins, due to an increase in below-the-operating-line items (interest expense and “special charges”). As a result, earnings per share growth (right chart) declines. From the perspective of the average acquisition, M&A tends to be dilutive to earnings growth over an extended period.
Figure 5 shows that return on equity and return on invested capital (ROIC) both decline relative to industry peers following a significant acquisition (left chart). This is partly a result of increased interest expense and other charges and, in the case of ROIC, partly due to a large rise in debt relative to peers (right chart).
Figure 6 shows the interplay of cash flow from financing, investing, and operating activities (left chart) following an acquisition. In the first year following an acquisition, while financerelated cash flow jumps, due to new debt and share issuance, investing cash flow drops,