In this opinion piece, Vinay B. Nair, a senior fellow at the Wharton Financial Institutions Center, points to some of the most common mistakes companies make during mergers. Nair is also a senior fellow at the Center of Law and Business at New York University and a Visiting Professor at the Indian School of Business.
In yet another demonstration of India’s growing buying power, the Tata Group is vying to acquire Jaguar and Land Rover from Ford Motors. If the deal were to close in the next couple of weeks, it would cap 10 months of record deal-making this year by corporate India. In the first 10 months of 2007 Indian firms have already spent a record $31.7 billion acquiring companies abroad. With 2006 witnessing only $9.9 billion outbound acquisitions, this has been a trend-setting year for Indian firms.
Acquisitions, outbound or not, have one common feature. The buyer pays the target firm a premium above its current market value. Underlying this willingness to pay a premium is the belief that the target would be worth more if it were owned by the buyer. This increase can arise from a reduction in combined costs (cost synergies) or an increase in combined sales (revenue synergies) due to the acquisition.
If these synergies are realized, the acquirer’s competitors are at a disadvantage. These rivals then seek their own targets. For example, consider the Tata Group: It acquired Corus soon after Mittal Steel bought Arcelor, creating the world’s largest steel company. Little wonder then that deals follow deals and takeovers typically occur in clusters within sectors. Indeed, several Indian steel companies have followed the Tata Group in buying targets overseas. Such activity, in part, was what drove the torrid pace of mergers during 2007, and that is unlikely to slow down next year. With several other deals in the pipeline, 2008 may set another new record. Amidst this frenzy, it is easy to forget the basics.
A key tenet for financial success in acquisitions is, “Do not overpay.” In other words, the price paid for the target should not exceed the value of the target to the buyer. Simple enough, right? Yet, judging by stock market reactions, this tenet is violated in most of the deals witnessed in the U.S., as shown in a 2001 study titled, “New Evidence and Perspectives on Mergers,” published in the Journal of Economic Perspectives. Perhaps the lessons from the U.S. experience are useful to corporate India as it brandishes its buying power.
When it comes to affecting the value of the target to the buyer, cost synergies and revenue synergies are very different. Most changes required to realize cost synergies are internal to the firm, so they tend to be realized faster — often within a year or two. For example, people often say that after a merger a company resembles Noah’s Ark: It has two of everything — accounting departments, finance departments, marketing departments, etc. Shedding some of this duplication is essentially an internal process — and for that reason such actions are less susceptible to reactions by competitors. This makes them less risky.
On the other hand, since cost synergies essentially come from replacing one firm’s method of producing by another’s, it might entail some political resistance, especially in cross-border deals. Many company owners — and politicians — would be hesitant to agree to an acquisition by an international firm if this meant that their workers would be laid off and replaced by lower-cost workers elsewhere. Recently, Ford’s union leaders at Jaguar and Land Rover supported Tata’s bid for these brands based on assurances of job security for workers in the UK.
Revenues at Risk
Revenue synergies, in contrast, depend not only on internal factors but also on the reactions of several players outside the firm, such as competitors and customers. They consequently take time, often longer than three years, to truly take effect. Beliefs about potential revenue growth also tend to fall short of expectations because they are affected by the actions that competitors take in response to the merger. Many acquirers, when they estimate the increases in sales due to the acquisition, assume the competitors will remain as they are today. In reality, rivals react to the acquisition and hatch their own plans to combat this expected increase in sales to the buyer. As a result, part of this “revenue synergy” simply evaporates. Several of the so-called synergies touted in “Internet deals” such as AOL-Time Warner fell into this trap. They projected much higher revenues than they were able to ultimately realize because of their competitors’ actions.
Revenue synergies also require a greater level of integration between the merged firms. Often this is a process fraught with the potential cultural conflict between the two organizations. Such cultural conflicts make the process of integration difficult. Often the conflict between divisions is so high that liberation turns out to be a better option than integration. The ill-fated Daimler-Chrysler merger is a classic illustration of this failure.
A good buyer should thus be realistic in assessing revenue synergies and cost synergies. Given the uncertainty associated with revenue synergies, a careful buyer should not consider a dollar of revenue synergies to be equivalent to a dollar of cost synergies.
There is nothing like practice to reduce the degree of uncertainty in one’s estimates of these synergies. This explains why most Indian companies are starting small when looking abroad. Even the steel companies in the news over the past year had previously completed several smaller deals. But one has to be sure that the lessons of the previous deal are applicable to the one at hand. There is nothing like overconfidence to ruin your estimates.
Is the Price Right?
To buy a company at the right — or the lowest price — it helps to be the only interested buyer. If possible, avoid competition. The best tactic for this is to think differently. Doing so makes it more likely that you will be the only one approaching a target. Additionally, targets that have a lower profile often face fewer buyers. They might be smaller firms or sometimes private firms.
Private targets have another advantage. Since owners of private firms typically have a large part of their wealth in the firm, they are less diversified and value their firm less than a diversified owner might. For a diversified firm, this creates a greater possibility of paying a reasonable premium to the seller and still not overpaying.
If a buyer does get into a competitive environment, the discipline to walk away at a pre-determined threshold price is critical. Many acquirers make the cardinal mistake of underestimating their competition. I have often heard executives from companies that are contemplating a merger make statements such as, “I can pay 10% more than another potential buyer offers because I can improve the cost structure by 10% more than he can.” Imagine what would happen if the other buyer were to say, “I can pay 10% more than what he offers because I can improve the revenues by 10% more than he can.” It would create a bidding war with one company trying to outdo the other in pushing up the acquisition price — and this works entirely to the seller’s advantage. U.S. real estate mogul Sam Zell, who recently sold Equity Office Properties, a major real estate investment trust, is a master of this strategy. Lack of respect for the competition can lead to hubris where the winner will almost surely overpay.
Companies sometimes also underestimate the importance of non-price dimensions in a merger. This is especially the case in cross-border deals. The support of workers and other non-shareholder groups is critical in cross-border deals. These groups support firms that have a good track record with respect to social factors. Mittal Steel benefited from their factory safety record in gathering support from the labor unions in France. This was an important ingredient in the outcome of the bidding war.
Indian companies that are prowling for targets to take over would do well to understanding these basic issues, because it can help them avoid the single biggest mistake that many new acquirers make — overpayment. The old saying “caveat emptor” — let the buyer beware — applies as much to a merger as it does to any other kind of purchase.