Material Adverse Change

Lessons from Failed M&As

Robert V. Stefanowski

• Publisher: Wiley
• Year: 2018
• ISBN:
  9781118236383
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Betriebliches Rechnungswesen

Boost M&A outcomes with less risk by learning from mistakes of the past

Material Adverse Change will help you close more successful mergers and acquisitions by analyzing the common root causes of deal failures from before the Great Recession to today. The time between signing and closing a deal is a particularly risky period where the buyer has committed to purchase the company, but the seller continues to operate it while waiting for regulatory approval or funding to close out the deal. A Material Adverse Change clause allows the buyer to back out of the transaction if certain adverse events occur during this period. By designing this safety net into the contract, you're free to take the time to examine records, meet with employees, and fully understand the legal issues at hand. If the target loses value during that time, in certain cases, you're free to walk away. This book explores the full power of the Material Adverse Change clause, and today's M&A in general. You'll dig into the real causes of M&A failure, and discover the traits and practices that lead to poor results as you learn how to avoid these common mistakes and drive more successful deals. Recent case studies highlight common mistakes made—and propagated—by otherwise intelligent people, so you can identify and eliminate these practices within your own organization.

A large acquisition is already a delicate balancing act. Why complicate it with the exponential risk by not doing your homework? This book shows you how to apply best practices to increase your chances of successful deals and avoid potentially career ending mistakes.

• Explore the true root causes of M&A failures of the past
• Analyze the personality traits that drive suboptimal outcomes
• Implement new practices to avoid mistakes and close successful deals

• Learn why common-sense errors are repeated over and over again

The M&A market has grown to become a major factor in the global economy, yet many buyers do less investigation than consumers making everyday purchases. Material Adverse Change shows you how to slash risk and improve your chances of completing better deals.

CHAPTER 1
Why Bad Deals Happen

This really is a merger of equals. I wouldn't have come back to work for anything less than this fantastic opportunity. This lets me combine my two great loves—technology and biscuits.

—Lou Gerstner, former chairman and CEO, IBM, commenting on Cisco's proposed acquisition of Nabisco from Kraft Foods

A PRACTICAL APPROACH TO MERGERS AND ACQUISITIONS

What do you look for when deciding on a bank to deposit your money? Given the recent large bank failures, the financial strength of the bank is certainly one main consideration. You may also be interested in the bank's customer service, checking account options, hours of operation, and so on. More financially experienced individuals will try to find the bank with the highest interest rates paid on customer deposits. For the most part, choosing a bank is a purely fact-based, rational decision.

Now assume that you are the CEO of a global company and are trying to decide what company to buy. Criteria will include the company strategy, quality of personnel, and of course the rate of return and profit you can earn. So it should be easy. Rank the companies for sale by their level of return and pick the highest one. For those of you who took business in college, remember the concept of net present value? You calculate the expected cash flows of the company and discount them by your firm's weighted average cost of capital. The project with the highest internal rate of return¹ (IRR) is the one you choose.

Many of the university students I teach assume that this simple, scientific, and straightforward approach is how it works in the real world. This is the way the math works. This is how it was explained in the college corporate finance classes.

My professor is a brilliant person—it must be right. It takes a long time to convince students that the real world is much more complicated than this. Subjective judgments, personal agendas, egos, and a whole host of other human emotions often have more impact on these decisions than the pure numbers suggest.

In my experience, a purely academic approach to mergers and acquisitions is rarely the best way to make a decision. For example, an absolute comparison of returns versus cost of capital may have been a primary driver at the start of Royal Bank of Scotland's (RBS's) process to purchase ABN AMRO. However, as the auction went along and competition for ABN intensified between RBS and Barclays bank, it became less about the numbers and more about the softer items such as each firm's reputation, the impact to stock price of winning or losing the auction, public perception of the deal, and the attitudes of employees and customers.

A CASE STUDY: RBS BUYS ABN AMRO

Many postmortems have been written on Fred Goodwin's relentless pursuit of ABN AMRO. Early in the process, several internal and external RBS constituencies began to question the true motivations around this acquisition. One RBS analyst said at the time, “Some of our investors think Sir Fred is a megalomaniac who cares more about size than shareholder value.”² But either these concerns never filtered up to the boardroom or, more likely, they were discussed and discounted; the momentum of a deal and commitment toward closing can often override very legitimate issues.

It must have been difficult to justify the ultimate purchase price of $96.5 billion when the initial bid from RBS in March 2008 was $92.4 billion. Did the fundamental operations and value of ABN AMRO improve by over $4.0 billion in the span of six months? In reality, a combination of poor integration, unrealistic projections, and a softening economy drove a significant loss in the value of ABN operations during this six-month period, and the price should have gone down, not up. An RBS trader commented at the time that “once you started to look around ABN's trading books, you realized that a lot of their businesses, where valuations were based on assumptions, were based on forecasts that were super-aggressive.”³

In hindsight, losing this deal may be the best thing that ever happened to Barclays and the CEO of Barclays Capital Bob Diamond. RBS never recovered from difficulty in integrating ABN AMRO, the poor asset quality, and the massive losses it incurred. In June 2007, RBS raised £12 billion of capital by issuing new shares in a rights offering to try to save the company from the massive overpayment and operating losses resulting from the ABN acquisition. At the time, this rights offering was the largest fundraising in the history of the British public equity markets; however, it still proved to be insufficient.

News of the serious issues associated with the acquisition of ABN was leaking to the market and the firm's capitalization decreased by more than a quarter—more than the total amount of capital raised by the rights offering itself. By October 7, 2008, RBS, its management team, its shareholders, and the U.K. government all realized that it was too late. The U.K. Treasury Select Committee started to provide emergency liquidity to RBS; in effect U.K. taxpayers were becoming the major shareholders in the new RBS.

In contrast, Barclays went on to be very successful. The bank has had some more recent issues, but Barclays had a strong enough balance sheet to withstand the Great Recession without bailout support from the government. Bob Diamond was ultimately promoted from the head of Barclays Capital to succeed John Varley as the head of the entire bank. While Diamond was dismissed from his post in 2012 for issues related to the LIBOR scandal, he was fortunate enough to have prolonged his tenure at Barclays by avoiding a disaster deal in ABN. In the world of M&A, winning the deal is not always the best outcome. The party that wins a competitive auction for a company is normally the party that is willing to pay the most! While this works out fantastically in some cases, it can cause problems for the buyers. As we saw with RBS, winning a deal may be the biggest curse of all.

MOTIVATIONS FOR DEALS

RBS's purchase of ABN AMRO seems truly illogical in hindsight. So why did it happen? Simple human nature is involved in all of these deals. It is easy to lose perspective, to forget the facts, and to become emotionally vested in the purchase. Many people can sympathize with this phenomenon. Have you ever paid more than you should have for a new home, a car, or a designer handbag because you became emotionally invested and just had to have it? Marketers all over the world depend on this human trait to sell product. As we see time and time again, it is no different in the “scientific” world of corporate finance.

Many CEOs are “Type A” personalities who like being in charge and enjoy the spotlight of the press. The battle for ABN was covered daily in the national press. While not intentional, it could be that the competitive nature of each CEO had as much to do with the rising price for ABN as the detailed acquisition models used to derive a fair price. In fact, by the time the purchase price rose to $96.5 billion, I imagine that the internal rate of return of the escalating bids for ABN AMRO was largely ignored while many of the softer issues were driving the ultimate decision.

A CASE STUDY: BANK OF AMERICA BUYS MERRILL LYNCH

The merger between Bank of America (BofA) and Merrill Lynch in September 2008 is another high-profile example of this phenomenon. Bank of America, headquartered in Charlotte, North Carolina, operated retail bank branches throughout the United States and the rest of the world. Originally founded in 1904, BofA had grown to be the largest retail bank in the United States.

Ken Lewis grew up in the southern United States, graduated from Georgia State University, and joined North Carolina National Bank in 1969. He became CEO of the successor organization, Bank of America, in 2001 upon the retirement of Hugh McColl. Lewis was admired for his strategic vision, execution of acquisitions, and ability to improve the operations of companies he acquired. By the mid-1990s, BofA had become a premier retail bank and Lewis was awarded “Banker of the Year” by American Banker in 2008 (American Banker, October 2008).

However, as a retail bank based in the southern United States, BofA did not have the prestigious reputation of the high-powered investment banks on Wall Street that were advising on multibillion-dollar acquisitions. Although widely respected, BofA was a large retail bank that took in consumer and corporate deposits and lent them out for car loans, home mortgages, leveraged loans, and other financing to individuals and corporations. BofA was headquartered in North Carolina, not New York City. Their core business was not as sexy as the billion-dollar transactions and initial public offerings being negotiated by investment banks making millions of dollars in fees for their firms and for themselves. While Lewis ran a first-class organization in its own right, it was and would always be considered second-tier to the global investment banks on Wall Street.

Merrill Lynch was a venerable investment bank on Wall Street with a heritage dating back to the early twentieth century. Founded by Charles Merrill and Edmund Lynch, Merrill became one of the leading providers of wealth management, securities, trading, corporate finance, and investment banking. The reputation Merrill held was very different from that of BofA. As a full-service investment bank headquartered on Wall Street, Merrill was absolutely included in the Wall Street elite. Over the years, Merrill's investment bank directed some of the largest and most visible transactions in the world of global financial services. Merrill's equity division had taken some of the most famous companies in the world public via initial public offerings. Merrill was able to attract the best recruits out of top colleges while improving the quality of management by tempting senior players from other Wall Street firms with employment contracts worth tens of millions of dollars.

In the late 2000s, Merrill decided to quickly expand its mortgage operations via internal growth and the acquisition of 12 major mortgage originators. The number of mortgage loans had exploded with the continued rise in the U.S. housing market. Merrill viewed mortgage lending as a way to diversify from its core M&A and equity underwriting business and bring in new revenue streams. A large part of this mortgage business included “subprime” mortgages, or mortgages made to borrowers with poor credit histories. These loans were attractive to Merrill because the bank could charge these customers a higher interest rate. Some of these borrowers had nowhere else to go and had to pay higher rates to secure financing. Many banks were worried about lending to these customers who had not paid back other loans, or historically paid loans late, resulting in a poor credit rating. However by 2006, over 20 percent of mortgage loans were to consumers considered to be subprime.

To manage exposure and generate fee income, the mortgages were packaged together into a pool and securitized to other investors. In other words, hundreds of mortgages were grouped into one pool of assets. Individual securities were then created that represented a percentage ownership in this broad pool of mortgages. An investor in one of these securities held a fraction ownership in the entire pool, enabling the investor to share in the risks and rewards of owning mortgage loans.

Financial professionals spoke about a “new paradigm” of risk. No one bank held the liability for the entire pool of mortgages any more. Rather, ownership of the individual securities was distributed among hundreds, if not thousands, of individual investors all over the world. The new theory was that if the pool of assets went bad and the mortgages were not repaid, it would not be a major global economic problem because the risk for any individual security holder was small. This eliminated the systematic risk posed by large borrowings to subprime mortgage holders held by one large bank because the securities were distributed in smaller sizes to multiple investors.

Securitization of mortgages became a massive business on Wall Street. Investment banks earned large fees by originating these loans or purchasing them from other borrowers and selling off the securities to others in the secondary market. Securitizations for other types of loans soon surfaced, such as automobile loans, corporate loans, credit card debt, and so on. These securities were called collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), depending on the type of loan pool.

As the global housing market boomed, banks started to lend more and more aggressively to weaker credits. This created more residential loans to supply the insatiable demand in the CDO market. It got to the point where “liar loans” were created that allowed individuals to take out home mortgages with no written evidence at all. In other words, a homebuyer coul...