Big Deal(s): What's Driving the M&A Frenzy?Published: January 24, 2007 in Knowledge@Wharton
2006 set a record for mergers and acquisitions worldwide. Deals totaled $3.79 trillion, 38% higher than in 2005, and 55 of the transactions were valued at more than $10 billion each, according to data from Thomson Financial. Europe was one of the big players, registering 39% more deals than in 2005 for a total of $1.43 trillion. The U.S. came in at $1.56 trillion, 36% higher than the year before. Private equity firms were major movers in this trend, responsible for 20% of global M&A activity and 27% of activity in the U.S., according to Thomson. How long will this M&A binge continue, and when it does come to an end, what will be the factors behind the retreat? Knowledge@Wharton asked management professor Harbir Singh, an expert on corporate acquisitions and restructuring, to offer his views on the M&A landscape.
Knowledge@Wharton: A recent report in The New York Times said that of 790 deals in the U.S. greater than $250 million between 1995 and 2001, only 3 in 10 have created meaningful value for shareholders. Why is this? Do mergers, in fact, do more harm than good?
Singh: I've been studying mergers for a very long time. I think what's fascinating is that this kind of question comes up routinely and has come up throughout the last 15 or 20 years. It's a good question because in a sense, mergers have asymmetric effects on different stakeholders. They don't have uniform effects across stakeholders.
There is always a degree of controversy surrounding M&A. So, one way of answering the question is to say that mergers are, generally speaking, good for sellers. Sellers typically get about 15%-25% premium on the pre-existing value of the firm, so they tend to do well. The evidence on buyers is more mixed.
The New York Times article says 3 in 10, but a lot of research says that it's probably 4 out of 10, buyers tending to make money and perhaps even 5 out of 10. And so buyers tend to essentially pay the fair market value for their candidate. What that means is because acquisition is usually initiated by the buyer, the buyer needs to insure that they have unique synergies. Just having synergy is not enough.
Just having synergy simply means that you'll pay out that synergy to the shareholders of the selling firm. So, it's good for sellers and it's good for 5 out of 10 buyers. There's a bit of a trend recently that suggests that buyers are getting smarter. They are now avoiding transactions that are questionable. They are not getting as caught up as much in the hype surrounding an industry or a type of transaction. And also buyers are paying slightly less premiums. So I think that when we look as this three years from now, we might see somewhat different data. It may not be very different, but buyers will look a little bit better.
The other way of thinking about this is that this is with respect to shareholders, but what about with respect to employees? There is evidence that in certain industries, particularly industries that have a high degree of excess capacity, employees of the selling firm tend to not do well in a merger, in the sense that there are significant lay-offs and so on. It's a mixed bag for employees.
I think that the last point I will make is, however, that a positive net effect of M&A can be that there are efficient ways to restructure firms and efficient ways of utilizing capacity. And so in some ways mergers are a natural outcome of market processes. I think that's the best way to look at mergers.
Knowledge@Wharton: One of the things that I find very interesting with the current wave of mergers that seems to be rising higher and higher is the active involvement of private equity firms, and also hedge funds to some extent, which put a lot of capital into these big deals. Two questions there, do you think that this involvement of private equity firms and mergers is going to continue? And secondly, is this a good thing or does it increase risk in the market?
Singh: I think that both are very interesting developments and, in particular, the rise of private equity in the last few years has been dramatic in the sense that they are making larger and larger transactions. Recently Qantas [Airways] was bought out at about $10.5 billion by a group of private equity partners So there are many, many large transactions being done by private equity players around the world.
That's the other interesting dimension -- that often these financial engineering type transactions were mostly U.S. centered. But now it's a global phenomenon. So the question is -- why do private equity people exist? Because they don't bring any new synergies to the table, so they're clearly not operating from synergies. So how is it that they can even function and pay a 15% to 20% premium on the pre-existing value of the assets?
There are two answers. One answer is that the private equity people actually are very good at restructuring firms. They are actually able to break down the firm into certain component businesses and resell certain businesses and recover some of the premium. And then with the remaining part of the firm, they find ways to create value by providing the managers with better incentives and also with tighter monitoring.
So one way of thinking is private equity players are more significant today, because they are agents for getting better productivity from assets. They're really not there for synergy; they're there for improving the economic productivity of assets. And, they are willing to make tougher decisions than pre-existing management teams can make. Will this trend continue? I think so far the trend is clearly gaining momentum.
However, I do think that there may be an excessive momentum with respect to private equity players. I think as valuations in the market start rising, that it will be harder for private equity players to actually have the margin beyond their premium paid to recover value. So, there are two possibilities.
One is that they are clearly very sophisticated buyers and they slow down on their own, as they see that the opportunities are drying up. The other possibility is that, just like other buyers, they keep gaining momentum and then they are subject to the "winners curse". And, after a couple of visible and unsuccessful transactions, they will also start pulling back.
Knowledge@Wharton: Some people suggest that so called mergers of equals are among the least successful. Is this true, and if so, why?
Singh: This is a very interesting issue because people have thought that mergers of equals were a way to reduce the stress around a transaction. The merger of Daimler and Chrysler was announced as a merger of equals. The creation of Citigroup [Citicorp and Travelers Insurance Group] was a merger of equals. We have had several such transactions where the public announcement suggests that both sides are equal.
It sounds very magnanimous and it sounds very comforting to employees and other stakeholders that this will be a smooth transition. However, there isn't much evidence that mergers of equals actually deliver value. That is partly because they may be denying the actual reality that the firms are not equal.
And as a result, the post merger integration activities tend to become more convoluted. This is because there are actual battles going on, behind the scenes and yet publicly it is being cast as a merger of equals. So the question to ask is, if mergers of equals are not very effective in post merger integration, why do people announce them as equals?
There are two possibilities. One is to essentially gain some good will in the early stages.... But the other reason is that, actually, when you have a merger of equals it's not clear who the buyer is and who the seller is. So actually the premiums paid on mergers of equals are a bit lower. And I think that may be the more significant reason.
So, one way of thinking about it is that if one can get away with paying a lower premium and integrate effectively, then calling something a merger of equals is okay. But, if the mergers of equals label causes too much confusion and a sense of betrayal, then it's not worth the effort.
Knowledge@Wharton: When you were talking earlier about the influence of private equity firms and mergers, it sounded so similar to the junk bond-financed mergers of the 1980s which talked about similarly extracting value by breaking up companies. Is there anything that makes the current wave of mergers different than past mergers?
Singh: That's a very interesting question. Actually, the private equity transactions are not very different from the leveraged buy-outs that were led by buy-out firms in the late 80's and early 90's. In fact, you can argue that it's probably a re-labeling of a pre-existing phenomenon, except that the degree of debt being carried now is not as high as it used to be.
So there is a change. In a sense, the leveraged buy-out activity in the 1990's was really driven by a very high degree of debt. The argument was that when you took that much debt, in a company that had stable cash flows, management became more disciplined. They wasted less money. And also there was a great tax incentive because you could deduct all that interest.
But then it became very difficult to operate for certain kinds of industries with such a high degree of debt. So the current private equity activity has a lower level of debt but is similar in other ways. It's similar in the sense that there are no new assets brought to the table. It's similar in the sense that it really relies upon the buyer's ability to assess intrinsic value. It's also similar in the sense that eventually they will sell the firm at some point to shareholders, again to get the premium and cash out.
Knowledge@Wharton: I know you've done a lot of research on why mergers succeed and why they fail. If you had to pick maybe two or three reasons in each category, what would you choose to discuss in terms of their success versus failure.
Singh: That's a fascinating issue because despite the significance of M&A, the success rate is low. It is about 40% and that's surprising. So how do you explain success? I would say there are probably three major factors that explain success. You have to manage three stages of the transaction effectively to achieve success.
The first is target identification -- identifying the module candidate. And in that, being willing to be different is important, i.e., having a unique strategy. Not following the herd is important, because if you follow the herd you are going to wind up overpaying. So that is the strategy identification piece.
That also includes, by the way, walking away from something that looks attractive. I think that's the hard part. So, I would say on the strategy end, being willing to be different is an important part of success.
I think that with the transactional piece, which is the next stage, the biggest issue is to be disciplined enough to walk away at your exit price. There's a lot of uncertainty surrounding the transaction. It's very difficult, in practice, to assign a numerical value to a living and breathing organization.
And it's very difficult therefore to know that you have hit your ceiling price and you absolutely should walk away. It's very tempting to re-visit your evaluation and say that you can throw in a little bit more money because in any case, you weren't very clear about the ceiling price. There are so many intangibles.
The third point in the transactional area is the tension, the complexity and the pace at which these transactions happen and which can also impair your judgment. So you have to make sure that your judgment remains reasonably rational through this high pressure and high velocity stage.
And then in the third stage with post merger, the key success factor is to actually deliver on the sources of value. That's extraordinarily difficult, which is why not many companies succeed because it is a complex situation. You're entering a different organization with its own history, with its own culture and also with some degree of resentment towards the acquirer.
I think a key success factor is to win people over quickly and to actually be able to implement the strategy which was the driver to begin with. So those are the success factors. In terms of why they don't work, fundamentally the first reason is overpayment.
It turns out that because the premiums are high, it's very difficult to exceed the premium paid with the synergy you have. And so even on the face of it, a module is not an easy transaction. It's made even more complicated by the excitement around the transaction and the market pressure to overpay.
The second reason is cultural conflict. It's very difficult to quantify cultural conflict. And, it's very difficult to identify and quantify cultural compatibility. The third reason is that the cash and the actual synergies get delayed -- they don't come in when they are supposed to come in.
Knowledge@Wharton: Is there a merger that you can think of where they did everything right, that you have done a case study on?
I can go back to an earlier transaction, which is good because we have enough data to now see what has happened with it. And that is IBM's acquisition of Lotus, which was some years ago. When IBM bought Lotus they paid $3.6 billion, which was seen as a lot of money.
It was a hostile transaction, not from IBM's side but from the existing management at Lotus. They were resisting strongly. And it turned out to be an acquisition that was enormously successful. Lotus Notes became the cornerstone of IBM strategy in the world of distributive computing. So it was an unqualified success.
Knowledge@Wharton: Maybe we can ask you to do a little bit of "crystal ball gazing" for the rest of the year. Do you expect any major mergers this year and if so, in what industries do you think there will be unusual activity?
Singh: Well, clearly one industry where we are already seeing a lot of activity is in telecommunications. You have the new AT&T and Cingular with the AT&T name coming in. And, I think that we'll see a lot more activity in telecommunications. The reason is that it appears that the economies of scale in telecommunications are such that we need larger entities than the ones that currently exist. So that's one industry where we'll see continued activity.
We'll also see some divestiture activity as the Federal Trade Commission looks at some of these transactions and feels that there is perhaps monopolistic activity in some areas. Another industry where we will see a lot of activity is in energy and utilities. That's an industry that is consolidating [kind of] at a steady pace. This is because, again, with the roll back of state based regulation, what you're seeing is that the natural economies of scale are causing a lot of interstate energy transactions and actually international energy transactions.
Then, the third area is financial services, where with the widespread use of information technology and the widespread availability of information a lot of banks, insurance companies and investment banks are merging. So, at least in those areas, we'll see lots and lots of activity.
Knowledge@Wharton: What's your opinion of Mittal Steel's $34 billion merger with Arcelor?
Singh: That was a very interesting transaction and it in some ways encapsulates some of the issues with respect to M&A. So Mittal Steel, very much below the radar screen, made lots of acquisitions of steel companies in less developed economies. They actually developed a system of identification, valuation and integration that was very effective.
They created a system that allowed them to buy steel plants, they quickly developed them and made them more productive and then they also improved their product line and created economic value. That was their process. And I think when they got to Arcelor they had done lots of transactions, including the acquisition of Inland Steel in the U.S., where they created a lot of value.
But Arcelor was a significant challenge because it's a major player, and as we all know, there was resistance in France and also in the EU to that transaction. Mittal had to take a different position with respect to Arcelor -- a less interventionist position. I have a lot of respect for Mittal Steel and I think that they have done a lot of good things.
The question really is, since they have been forced to do something different from what they normally do, would they be able to realize as much value as they were able to before? Now, already we are seeing that Mr. Mittal is starting to assert himself with respect to Arcelor, which I think is a good thing because they have to be able to implement their strategies.
But then, there's a delicate line that he has to walk, because, if this is seen as [kind of] reneging on prior commitments, then there will be a lot of organizational resistance to his strategies. So I would think that this transaction is going to be the one that will either continue the momentum or really slow down the momentum in the future.
Knowledge@Wharton: Speaking of Mittal Steel, you know we've seen in recent times, that a number of Indian companies have become quite active in the M&A area. The most publicized example I think was Tata Steel's effort to take over Corus. Could you speak a little bit about your view of what's going on with these Indian mergers and what your prognosis is?
Singh: One of my co-authors and I have done a study on M&A in India for about 12 years, starting in 1992. We found some very interesting patterns. In the first six years after liberalization in the Indian economy, the mergers were mostly successful. The reason for this was that the capital market was starting to accept these transactions and so there were bargains out there. You could even buy unrelated companies and make some money.
But then in the second six years, roughly from 1998 to 2004, the market began to look more like the international market, the U.S. market, where you really had to have some unique synergies in order to create value. So the success rates, in other words, have become similar to the U.S. and also are much more around having a viable strategy driving the transactions and not just a deal making approach.
Companies like the Tatas and Reliance and others have developed acquisition capabilities through these transactions domestically. Tata has bought a lot of tea companies. As a group it has bought software companies. It has also done other transactions. They bought Daewoo's assets on the automobile side. So, as a group, they have developed certain capabilities to identify and create value in these transactions.
I think that with the Corus Steel transaction, there was a lot of due diligence done. I think that it is very likely to work. In a sense, it's similar to the Mittal Steel concept of coming in and providing new and different ways of managing the assets. I think that that's an interesting trend and I think that it will continue. And I think that they will remain disciplined because they are entering an international market and they know that they have to be very careful about hard currency. So I expect that those transactions are likely to go well.