Before we get down to the detail of this article, let’s think about Daimler’s merger with Chrysler for 36 billion dollars. Only a few years after the merger completed, Daimler had failed to realise the expected synergies with the Chrysler business unit so negotiated a deal to sell 80% of Chrysler for 7 billion dollars. However, this didn’t represent the true capital loss. You see, due to the pay down of debt amongst other expenses, Daimler actually paid around 600 million dollars to drop Chrysler from their portfolio, a catastrophic failure by anyone’s standards.
So, why did this 36.6 billion dollar loss happen in this instance and why do acquisitions fail so frequently? Let’s discuss.
Before we go any further, let’s cover off the two basic kinds of deal which can occur. The friendly deal or the hostile takeover.
A friendly deal is when one company acquires another and the selling party is accepting of a deal whereas a hostile takeover is where the target firm is not cooperative. So, the buying-firm circumvents the company management and goes directly to shareholders to buy a majority stake in the business.
Let’s say that I want to buy a company that is trading on the stock exchange. For simplicity sake, let’s say their stock price is 10 dollars per share, valuing the company at 100 million dollars.
If I were to offer to pay 100 million dollars for the company, I probably wouldn’t be successful. Why? Because the shareholders want a return on their investment, they don’t just want to recoup their initial investment value – if they wanted to do that, they would have sold their shares on the open market already.
As such, I need to add a premium to the price, providing the shareholders with the returns they desire. But, how do I know how much premium to add? Is it worth adding a premium? Can I recover that additional capital investment?
Quite often, you’ll see a company offering 20 to 40 percent more than the market value for the company that they hope to acquire. In this instance, the acquiring firm believes it’ll be worth more as part of their business than it is in its current form. That is to say, they believe that they can realise economies of scope which are not currently achieved by the existing management.
While the shareholders of the target firm receive a premium for their shares, it can have a negative impact on the acquiring firms share price, which often drops during an acquisition as the market doesn’t believe that they can realise synergies in excess of the premium price they paid for the firm. This, coupled with the historic evidence that many deals do not produce long run returns, makes the markets sceptical.
There are quite an number of reasons for this. First and foremost, as the buyer understands the value of the economies of scope and synergies between the two companies, so does the seller. Therefore, if the seller believes that the synergies are worth 10 million dollars, then that will be reflected in the price that they’re willing to sell for. By doing their own analysis, they can negotiate hard with the buyer.
You also have the concept of bidding wars. This is where multiple firms bid for the same company. In this situation, the various bidders don’t know what others value the company at or the value of their bids. In this case, the highest bidder wins. This may result in the company over paying for the acquisition- we refer to this as the winners curse. Yes, they won the bid, but they paid too much.
There is also the concept of herd behaviour. A risk adverse approach to growing an organisation can be to copy other leading competitors. For example, if the others are vertically integrated, you may choose to do the same to be risk adverse, rather than going against the grain. If you make the wrong decision, at least the other players in the market did too! We saw that when Disney acquired ABC, other competitors in the industry started to follow suit – this herd behaviour can inflate costs.
The most prevalent reason for overpaying is simple. It’s very difficult to measure and value synergies between yourself and a company that you’ve never worked for or operated. Even carrying out thorough due diligence to study and understand the firm, you may not get close to a full realisation of all the moving parts within the company and you may underestimate the cost of integrating the two companies together.
Usually not enough attention is paid to the cost of achieving synergies. It’s therefore vital that you analyse the anti-synergies – the losses incurred when integrating two firms together.
What is agency theory? Well, we see the separation of ownership and control in a large public traded company. The executive team run the company day to day and the shareholders sit back to reap their rewards.
The shareholders and the executive team have different interests. The shareholders want to maximise the return on their investment while the CEO wants to run a bigger and bigger organisation to achieve greater recognition in the press.
So why is this a problem? Well let’s look at the process of valuing a company.
The challenge when valuing a company is that they include assumptions which can vary widely depending on who’s conducting the analysis. Quite often conclusions are highly sensitive to a few core assumptions. Such as how much you expect revenue to grow, what the analyst thinks will happen to operating margins, how challenging the analyst believes it will be to realise synergies. We can see dramatic changes in value as you tweak assumptions very slightly.
Why would someone tweak the assumptions? That’s simple, they will tweak the assumptions until the valuation supports the outcome that they want to achieve. That is to say, it’s easy to make it falsely seem to be a good idea to buy a company when the reality is quite the opposite.
Why would someone want to buy a company, knowing it wouldn’t return on investment? To increase their personal stock value – that is, their perceived value in the job market. After all, the bigger the company, the more the CEO is recognised and the more compensation they receive from their employer.
Executives have another trick up their sleeve. To further reinforce the notion that the acquisition is a good idea, they talk more about cost synergies than revenue synergies. That is the cost savings by having the two companies working together. They don’t talk about new opportunities for product sales. They do this because it’s easier to be explicit about cost synergies such as workforce reduction or shared equipment than it is to provide accurate figures for new revenue streams.
So you can see that through clever analysis and carefully worded sales pitches surrounding the acquisition, the agent (the CEO) can have huge sway and influence the decision making process.
While you can go some way to aligning interests by giving stock options or a bonus plan through which the executives are rewarded for doing better for the shareholders, it’s not a perfect solution and often proves ineffective.
In summary, we can see that acquisitions are difficult to make work as integration of two companies is complex and the expected synergies are not always realised.
It’s difficult to value the acquisition correctly and is very easy to over estimate the value of the synergies you hope to create and underestimate the costs to achieve those synergies.
We also have the issue of agency theory, whereby irrational investments are made, to provide the CEO with more publicity. Shareholders need to seek a way to control this, perhaps through incentives or a bonus plans that rewards the executives for looking after the interests of the shareholder.
Ultimately, due diligence and a well thought out integration strategy are key to a successful acquisition.