Michael Mauboussin on To Buy Or Not To Buy: A Checklist For Assessing Mergers & Acquisitions
- Companies spend more on mergers and acquisitions (M&A) than any other alternative for capital allocation.
- Empirical analysis shows that M&A creates value in the aggregate, but that the seller tends to realize most of that value.
- While the market’s initial read of a deal is not perfect, there does not appear to be a bias.
- Careful studies show that value creation is largely independent of EPS accretion or dilution.
- Buyers see their stock rise when the present value of synergies exceeds the premium they pledge to the seller.
- The form of financing and category can send signals about a deal’s merit.
- We suggest answering four questions in order to assess mergers and acquisitions: How material is the deal? What is the market’s likely reaction? How did the buyer finance the deal? Which strategic category does it fall into?
Companies spend more on mergers and acquisitions (M&A) than any other alternative for capital allocation.1 For many companies, M&A is the most significant and costliest course to redistribute corporate resources and pursue strategic goals. Since 1995, M&A volume has averaged 8 percent of the equity market capitalization in the U.S. and the world. As a result, nearly all companies and investment portfolios will feel the effect of M&A at some point.
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Exhibit 1 shows the dollar amount of M&A, as well as M&A as a percentage of market capitalization, from 1980 to 2016. M&A tends to follow the stock market closely, with more activity when the stock market is up.2 Volume in 2016 was down 17 percent versus that of 2015, but remained strong in a historical context. The outlook for 2017 is also robust.3
Companies that act early in an M&A cycle tend to generate higher returns than those that act later. The first movers enjoy the benefits of a larger pool of targets and cheaper valuations than companies that buy later in the cycle. Cheap and accessible financing prompts action by buyers at the end of the cycle. So do bandwagon effects, or what Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, calls the “institutional imperative.”4
Empirical analysis shows that M&A creates value in the aggregate, but that the seller tends to realize most of that value.5 Exhibit 2 shows a measure that McKinsey & Company, a consulting firm, calls “deal value added.” Deal value added is the percentage change in the combined market capitalizations of the buyer and seller from two days before to two days after the deal is announced. This has averaged about 6 percent over the past 20 years. Deal value added was 8 percent in 2016 and has averaged near 12 percent since the financial crisis. That the sellers realize most of the deal value added suggests that the buyers generally pay a full price for the companies they acquire.
Exhibit 3 shows McKinsey’s calculation of the percentage of deals that create value for buyers. A buyer creates value if its stock goes up relative to the market around the announcement date. This has averaged 42 percent over the past 20 years, with an average of 38 percent from 1997-2009 and 50 percent from 2010-2016. The figure was below 50 percent in 2015 and 2016.
Alfred Rappaport, a professor emeritus at the Kellogg School of Management, and Mark Sirower, a principal with Deloitte Consulting, explain why creating value through M&A is so challenging for a buyer.6 First, if the premium is too large the buyer cannot recoup its investment even if the deal makes strategic sense. Second, often competitors can replicate the benefits of a deal or take advantage of the buyer’s lack of focus as it goes through an integration process. Third, M&A requires payment up front for benefits down the road. This makes investors legitimately skeptical. Finally, M&A deals are generally costly to reverse.
One comment we hear consistently from executives is that the stock market is short-term oriented and fails to recognize the virtue of the announced deal. Mark Sirower and his colleague, Sumit Sahni, studied this assertion. Exhibit 4 summarizes their findings, which are based on an analysis of more than 300 deals.7 The first observation is that about one-third of the deals (103 of 302) result in a stock price for the buyer that is initially higher, net of the market’s change. This is consistent with past studies. Next, there is a clear correlation between the size of the premium the buyer paid, as seen in the column on the right, and the announcement return, located in the middle column. Small premiums lead to positive returns and high premiums generate negative returns.
Sirower and Sahni revisited the deals one year later to test the accuracy of the market’s initial reaction. Deals that were initially positive stayed positive overall, with a one-year total shareholder return of 4.9 percent. More than half (52 of 103) of the deals that were initially positive remained positive. Deals that were negative stayed so on average, with a total shareholder return of -9.0 percent. Two-thirds of the negative deals (133 of 199) continued to be negative.
This suggests that while the market’s initial reaction is not perfect, there does not appear to be a bias. Indeed, if there is a bias it is that the market’s reaction is too optimistic, as one-half of the positive deals turned negative but only one-third of the negative deals turned positive.8
The story for buyers should not come across as too dour. There are ways to improve the likelihood of a deal being successful. One factor that can work in favor of buyers is the source of financing. Research shows that the stock market likes cash deals more than stock deals.10 There are a number of plausible explanations for this. First, you can think of a deal financed with stock as two separate transactions: the buyer sells stock to the public and then uses the proceeds to acquire the target. Managements generally sell stock when it’s expensive, providing the market with a negative signal.
Second, the buyer takes on all of the deal’s risk and reward in a cash transaction. The buyer shares the risk and reward with the seller in a stock-for-stock deal. A stock deal is a weaker signal of conviction than a cash deal.11
Exhibit 5 shows the mix between deals that are all cash and those that are all stock or a combination of cash and stock from 1980 to 2016. In recent years, cash deals have been a higher percentage of the total than the long-term average. This reflects sizable cash balances, good access to the debt markets, and the perception of many executives that the stocks of their companies remain undervalued.
Another empirical finding is that not all types of deals have the same chance of success. Peter Clark and Roger Mills, finance experts who focus on M&A, found that deals they call “opportunistic,” where a weak competitor sells out, succeed at a rate of around 90 percent. “Operational” deals, or cases where there are strong operational overlaps, also have an above-average chance of success. The rate of success varies widely for “transitional” deals, which tend to build market share, as the premiums buyers must pay to close those deals can be prohibitive. Finally, the success rate of “transformational” deals, large leaps into different industries, tends to be very low.9
Analysis of the motivation for M&A also reveals a role for management hubris. This creates heated bidding among potential buyers and leads to what economists call the “winner’s curse.”12 The winner’s curse describes a case when a company is the “winner” by bidding the highest price for a target but suffers from a “curse” because it overpays.
Companies spend more on M&A than any other capital allocation alternative. Clearly, executives do deals in an effort to improve their company’s strategic and financial position. But volumes of research show that the primary winners are the sellers, not the buyers. This is consistent with competitive and efficient markets, where it is common for sellers to earn the economic rents.
The empirical research also shows that the stock market is reasonably good at assessing the merit of a deal. As a group, investors have to judge whether the buyer will get more than what it pays for. While the market does not always get it right, an encouraging point for active investors, there does not appear to be a systematic bias.
Certain factors can improve the probability of success from the buyer’s point of view. Having a deal that makes strategic and financial sense is vital. Analysis of deal types can help identify deals with a higher probability of success. How a company pays for a deal is also instructive. Cash deals fare better than stock deals.
We now present a checklist for M&A analysis, which provides a consistent, rigorous, and sound way to assess the merit of a deal. To illustrate the concepts, we include our study of 126 deals announced in 2015 and 2016 between public U.S. companies where the buyer had a market capitalization of $500 million or more. The checklist is useful for investment managers, sell-side analysts, and companies that seek to create shareholder value. We finish our discussion with two detailed case studies. The appendix lists all of the deals in our sample.
The M&A Checklist
Investors should answer the following questions when companies announce a deal:13
- How material is the deal for the shareholders of the buying and selling companies?
- What is the stock market’s likely reaction?
- Is the buyer sending a signal by choosing to pay with stock or cash?
- What strategic category does the deal fall into?
How Material Is the Deal?
The first question is whether the deal is likely to have a material impact on shareholder value. Shareholder value at risk (SVAR) measures the potential risk to shareholders of the buyer in the event that synergies do not materialize. SVAR provides an immediate and accurate assessment of how much a deal is likely to affect the shareholders of the buyer.
Since SVAR is a percentage measure of the acquirer’s potential downside, it quantifies the extent to which a company is risking the firm’s value on the deal. Low SVARs suggest limited upside or downside for the buyer. High SVARs may portend large changes in the buyer’s stock price.14
To calculate SVAR you need to determine the premium the buyer pledges and how the buyer intends to pay for the deal. For a cash deal, the SVAR is simply the premium divided by the equity market capitalization of the buyer. In a stock-for-stock deal, the SVAR is the premium divided by the combined market capitalizations of the buyer and seller (including the implied premium).
Here’s a simple example. Assume the equity market capitalization is $2,000 for the buyer and $800 for the seller. The buyer bids $1,000 in cash for the seller, representing a premium of $200, or 25 percent.
The SVAR is $200 divided by $2,000, or 10 percent. In other words, the $200 premium is a wealth transfer from the buyer to the seller if the combined businesses realize no synergies.
What if the deal is financed with stock instead of cash? Generally the seller receives a ratio of shares of the buyer. That means that if there are no synergies, the seller won’t receive what the buyer has pledged.
The SVAR in this case is the $200 premium divided by $3,000, or 6.7 percent. The SVAR in a stock-for-stock deal is always lower than that for a cash deal because the seller becomes an owner in the combined firm and thus assumes a portion of the risk.15
Premium at risk measures the risk that a seller assumes if there are no synergies. In a cash or fixed-value deal, the seller’s risk is only the probability of the deal falling through. In a fixed-share offer, the value the seller ultimately receives is a function of the buyer’s stock price. If the market perceives that the buyer is overpaying, it will drive the buyer’s price down and hence reduce the acquisition value proportionately.
To continue with our example, the premium at risk is zero for a cash deal. The premium at risk for a stock deal is 33.3 percent because the seller will not receive the full premium in the case that no synergies materialize.
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