The Synergy Trap

Mark L. Sirower

• Publisher: Free Press
• Year: 2010
• ISBN:
  9781439137703
• Topic: Business
• Subtopic: Business General
• Index: Business

With acquisition activity running into the trillions of dollars, it continues to be a favorite for corporate growth strategy, but creating shareholder value remains the most elusive outcome of these corporate strategies—after decades of research and billions of dollars paid in advisory fees, why do these major decisions continue to destroy value? Building on his groundbreaking research first cited in Business Week, Mark L. Sirower explains how companies often pay too much—and predictably never realize the promises of increased performance and competitiveness—in their quest to acquire other companies. Armed with extensive evidence, Sirower destroys the popular notion that the acquisition premium represents potential value. He provides the first formal and functional definition for synergy -- the specific increases in performance beyond those already expected for companies to achieve independently. Sirower's refreshing nuts-and-bolts analysis of the fundamentals behind acquisition performance cuts sharply through the existing folklore surrounding failed acquisitions, such as lack of "strategic fit" or corporate culture problems, and gives managers the tools to avoid predictable losses in acquisition decisions. Using several detailed examples of recent major acquisitions and through his masterful integration and extension of techniques from finance and business strategy, Sirower reveals: -The unique business gamble that acquisitions represent
-The managerial challenges already embedded in current stock prices
-The competitive conditions that must be met and the organizational cornerstones that must be in place for any possibility of synergy
-The precise Required Performance Improvements (RPIs) implicitly embedded in acquisition premiums and the reasons why these RPIs normally dwarf realistic performance gains
-The seductiveness and danger of sophisticated valuation models so often used by advisers The Synergy Trap is the first exposé of its kind to prove that the tendency of managers to succumb to the "up the ante" philosophy in acquisitions often leads to disastrous ends for their shareholders. Sirower shows that companies must meticulously plan—and account for huge uncertainties—before deciding to enter the acquisition game. To date, Sirower's work is the most comprehensive and rigorous, yet practical, analysis of the drivers of acquisition performance. This definitive book will become required reading for managers, corporate directors, consultants, investors, bankers, and academics involved in the mergers and acquisitions arena.

Part 1

UNCOVERING THE RULES OF THE GAME

1

Introduction: The Acquisition Game

Many managers were apparently over-exposed in impressionable childhood years to the story in which the imprisoned, handsome prince is released from the toad’s body by a kiss from the beautiful princess. Consequently they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price they’d pay if they made direct purchases on their own? In other words investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses better pack some real dynamite. We’ve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.

—Warren Buffett, 1981 Berkshire Hathaway Annual Report

The 1990s will go down in history as the time of the biggest merger and acquisition (M&A) wave of the century. Few, if any, corporate resource decisions can change the value of a company as quickly or dramatically as a major acquisition.

Yet the change is usually for the worse.

Shareholders of acquiring firms routinely lose money right on announcement of acquisitions. They rarely recover their losses. But shareholders of the target firms, who receive a substantial premium for their shares, usually gain.

Here’s a puzzle. Why do corporate executives, investment bankers, and consultants so often recommend that acquiring firms pay more for a target company than anybody else in the world is willing to pay? It cannot be because so many acquisitions turn out to be a blessing in disguise. In fact, when asked recently to name just one big merger that has lived up to expectations, Leon Cooperman, the former cochairman of Goldman Sachs’s investment policy committee, answered, “I’m sure that there are success stories out there, but at this moment I draw a blank.”¹

It doesn’t make sense. For over thirty years, academics and practitioners have been writing books and articles on managing mergers and acquisitions. Corporations have spent billions of dollars on advisory fees. The platitudes are well known. Everyone knows that you should not pay “too much” for an acquisition, that acquisitions should make “strategic sense,” and that corporate cultures need to be “managed carefully.” But do these nostrums have any practical value?

Consider. You know you’ve paid too much only if the acquisition fails. Then, by definition, you have overpaid.

But how do we predict up front whether a company is overpaying for an acquisition—in order to prevent costly failures? What exactly does the acquisition premium represent, and when is it too big? What is the acquirer paying for? These are the details, and the devil is in them.

This book returns to first principles and precisely describes the basics of what I call the acquisition game. Losing the game is almost guaranteed when acquirers do not realize that acquisitions are a special type of business gamble.

Like a major R&D project or plant expansion, acquisitions are a capital budgeting decision. Stripped to the essentials, an acquisition is a purchase of assets and technologies. But acquirers often pay a premium over the stand-alone market value of these assets and technologies. They pay the premium for something called synergy.

Dreams of synergy lead to lofty acquisition premiums. Yet virtually no attention has been paid to how these acquisition premiums affect performance. Perhaps this is because the concept of synergy itself has been poorly defined.

The common definition of synergy is 2 + 2 = 5. This book will show just how dangerous that definition is. Pay attention to the math. The easiest way to lose the acquisition game is by failing to define synergy in terms of real, measurable improvements in competitive advantage.

A quantifiable post-merger challenge is embedded in the price of each acquisition. Using the acquisition premium, we can calculate what the required synergies must be. Often this calculation shows that the required performance improvements are far greater than what any business in a competitive industry can reasonably expect.

By analyzing the acquisition premium, we can determine in advance when the price is far above the potential value of an acquisition. We can also show why most purported synergies are like the colorful petals of the Venus flytrap—dangerous deceivers. But managers who analyze the acquisition premium and understand the concept of synergy will not get caught. They can predict the probability and the amount of shareholder losses or gains.

My claim is that most major acquisitions are predictably dead on arrival—no matter how well they are “managed” after the deal is done.

The M&A Phenomenon

Mergers and acquisitions are arguably the most popular and influential form of discretionary business investment. On the single day of April 22, 1996, with the announcement of the Bell Atlantic—NYNEX merger and Cisco Systems’ acquisition of Stratacom, over $27 billion of acquisitions were announced. For 1995, the total value of acquisition activity was over $400 billion—for 1997, over $1 trillion.² By comparison, in the aggregate managers spent only $500 billion, on average, over the past several years on new plant and equipment purchases and a mere $130 billion on R&D.³

Acquisition premiums can exceed 100 percent of the market value of target firms. Evidence for acquisitions between 1993 and 1995 shows that shareholders of acquiring firms lose an average of 10 percent of their investment on announcement.⁴ And over time, perhaps waiting for synergies, they lose even more.⁵ A major McKinsey & Company study found that 61 percent of acquisition programs were failures because the acquisition strategies did not earn a sufficient return (cost of capital) on the funds invested.⁶ Under the circumstances, it should be natural to question whether it is economically productive to pay premiums at all.

Logically, we should expect that managers choose an acquisition strategy only when it offers a better payoff than other strategic alternatives. But there are several pitfalls inherent in acquisitions because they are, in fact, a very unique investment.

First, since acquirers pay a premium for the business, they actually have two business problems to solve: (1) to meet the performance targets the market already expects, and (2) to meet the even higher targets implied by the acquisition premium. This situation is analogous to emerging technology investments where investors pay for breakthroughs that have not yet occurred, knowing that competitors are chasing the same breakthroughs. However, in acquisitions, the breakthroughs are called “synergies.”

I define synergy as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently. In other words, managers who pay acquisition premiums commit themselves to delivering more than the market already expects from current strategic plans. The premium represents the value of the additional performance requirements.

Second, major acquisitions, unlike major R&D projects, allow no test runs, no trial and error, and, other than divesting, no way to stop funding during the project. Acquirers must pay up front just for the right to “touch the wheel.”

Finally, once companies begin intensive integration, the costs of exiting a failing acquisition strategy can become very high. The integration of sales forces, information and control systems, and distribution systems, for example, is often very difficult to reverse in the short term. And in the process, acquirers may run the risk of taking their eyes off competitors or losing their ability to respond to changes in the competitive environment.

Legendary and successful acquirers such as Bestfoods, Cooper Industries, and Emerson Electric have learned over time and implicitly understand the fundamentals of the game.⁷ But most companies make very few major acquisitions and often hire outside advisers to do the acquisition valuations (called fairness opinions). A Boston Consulting Group study found that during the pre-merger stage, eight of ten companies did not even consider how the acquired company would be integrated into operations following the acquisition.⁸ It is no wonder that often the acquirer loses the entire premium—and more. Escalating the commitment by pouring more money into a doomed acquisition just makes things worse, perhaps even destroying the acquirer’s preexisting business.

The objective of management is to employ corporate resources at their highest-value uses. When these resources are committed to acquisitions, the result is not simply failure or not failure. Instead there is a whole range of performance outcomes.

Shareholders can easily diversify themselves at existing market prices without having to pay an acquisition premium. My analysis in this book shows that acquisition premiums have little relation to potential value and that the losses we observe in the markets to acquisition announcements are predictable. What do acquiring firm executive teams and advisers see that markets do not?

The most obvious answer to this question is synergy, yet anecdotal evidence suggests that managers are somewhat reluctant to admit that they expect synergy from acquisitions. In the battle for Paramount, synergy became the embarrassing unspoken word. And Michael Eisner has stated that he does not like to use the “s” word regarding Disney’s acquisition of CapCities/ABC.⁹ So why do these executives pay premiums? Is it that those who do not remember the past are thoughtlessly repeating it?

The 1980s set all-time records for the number and dollar value of corporate mergers and takeovers in the United States, firmly displacing the famous merger wave of the 1960s. More than 35,000 deals worth almost $2 trillion were completed during the 1980s, with the average size of a deal reaching over $200 million in 1988 and 1989.¹⁰ Advisory fees alone totaled over $3.5 billion in the peak years, 1988 and 1989.¹¹

The merger and acquisition field is well established. Since 1980, managers have allocated over $20 billion to investment banking and other advisory fees to help formulate and ensure the success of their acquisition strategies. In addition to professional advisers, there are academic courses: leading universities give week-long seminars to packed houses all over the world, and the American Management Association has an extensive program on M&A. Yet despite all of this advice, many fail.

As Bruce Greenwald, a professor at Columbia Business School has said: “Once you see the truth about something it is obvious, but there are many seemingly obvious things that simply are not true.” Obvious but untrue advice and folklore about acquisitions has led to bad business decisions. Why in fact do some acquisitions lose more money than others?

Back to First Principles: The Acquisition Game

A bad acquisition is one that does not earn back its cost of capital. Stock market reactions to mergers and acquisitions are the aggregate forecasts of investors and analysts around the world of the expectations of the value of the investment. What does it mean when these sophisticated capitalists bid down the stock of acquiring firms and bid up the stock of targets?

The theory of the acquisition game and the synergy trap is rooted in the Nobel Prize—winning research of Professors Franco Modigliani and Merton Miller (M&M). The M&M propositions and their pathbreaking research on valuation begin with the assumption that the value of a firm (V) is equal to the market value of the debt (D) plus the market value of the equity (E):¹²

V = D + E.

Think of this as an economic balance sheet where the market value of claims (the debt and equity) is a function of the expected earnings stream coming from the assets. You can divide the claims any way you like, but the value of the firm will remain the same. In the words of Merton Miller, “Think of the firm as a gigantic pizza, divided into quarters. If now you cut each quarter in half or in eighths, the M and M proposition says that you will have more pieces but not more pizza.”¹³

The application of this principle is crucial to understanding what it means for acquiring firms to lose huge chunks of market value following acquisition announcements. When you make a bid for the equity of another company (we will call this the target company), you are issuing claims or cash to the shareholders of that company. If you issue claims or cash in an amount greater than the economic value of the assets you purchase, you have merely transferred value from the shareholders of your firm to the shareholders of the target—right from the beginning. This is the way the economic balance sheet of your company stays balanced.

Markets give estimates of this range of value transfer through changes in share prices. The idea of the transfer of value is the stepping-off point for the development of the acquisition game. In short, playing the acquisition game is a business gamble where you pay up front for the right to control the assets of the target firm, and earn, you hope, a future stream of payoffs. But while the acquisition premium is known with certainty, the payoffs are not. What, then, is synergy?

Investors around the world have already valued the future expected performance of the target firm. That value equals the pre-acquisition share price. These investors’ livelihoods are based on paying what the performance is worth. So synergy must translate into performance gains beyond those that are already expected. Simply put, achieving synergy means competing better. But in current hypercompetitive markets, it is a difficult challenge just to achieve the expected performance that is already built into existing share prices—at a zero premium. What happens when we raise the bar?

Because markets have already priced what is expected from the stand-alone firms, the net present value (NPV) of playing the acquisition game can be simply modeled as follows:

NPV = ...