Dozens of studies have shown that most mergers and acquisitions fail to create value, and many of them destroy value. In fact, finance guru Aswath Damodaran has noted, "More value is destroyed by acquisitions than any other single action taken by companies." Why do so many mergers and acquisitions fail to create value? And how could so many smart people strike so many disappointing deals? Here are the four most common reasons:
1. It's far easier to overpay for a target than to get a bargain.
Whether you're negotiating with the owner of a privately-held firm (who knows far more about the firm's resources and prospects than you do), or you're trying to buy a majority share of the stock of a publicly-held firm (and bidding the price up well over the pre-acquisition price in the process), the odds are stacked against you. You are almost always going to pay more - often significantly more - than the firm is currently worth. If you didn't, the target's current owners wouldn't sell. Their outside option is always to hold or sell to another bidder at a higher price. That means your acquisition is only going to pay off if you know something the market doesn't know, or you can do something significantly better with that firm's assets than its current owners are doing. This leads to the second reason...
A significant body of research suggests that the managers of acquiring firms often overestimate their ability to manage or assess the prospects of the target firm. Overestimation is especially likely when the sources of value sought in an acquisition are nebulous allusions to potential future synergies (e.g., "With our unrivaled content and their access to distribution, we can develop exciting new products for the digital economy"). If the source of value sounds fluffy, walk away quickly.
3. Agency reasons.
Sometimes managers want acquisitions for reasons that have nothing to do with shareholder value. It's well established, for example, that the pay, perquisites and other benefits managers receive is strongly related to firm size. Furthermore, managers often have too much of their personal wealth tied to the firm they manage. This means they may be extremely under-diversified. Their solution? Diversify the firm, even if that's not in the interest for the other shareholders (who may more easily and inexpensively diversify themselves by holding shares in other firms). There's another agency problem that is often overlooked, and that is the agency of the investment banker putting the deal together. All deals are good deals to a banker who is going to receive a fee for putting it together. That's something we could (and should) fix, but that's a topic for another article.
4. Execution problems.
Sometimes a deal has some major sources of potential value. Perhaps manufacturing could be consolidated, enabling the firm to shutter some plants and increase capacity utilization. Perhaps bringing multiple product lines under a single brand could lead to major advertising benefits or savings. However, to achieve these sources of value often requires major integration of the firms. That can include painful choices. Whose plants get shut down? Whose employees get laid off? Whose brands are discontinued? Even when we are willing and able to make these changes, they can be difficult and time consuming, distracting both firms from their core activities. Identifying sources of potential value and harvesting them are two different things.
This article is part one of a two-part series; next up: read about the major sources of value in a merger and tell the difference between star deals and disasters in the making.