Is the Whole Greater Than the Sum of the Parts?...

As value investors, we spend our time trying to identify firms whose shares are mispriced by the market. This work often leads us to examine companies that are responding to a range of challenges such as rapid technological change or intensifying competition. Under these circumstances, managers often turn to acquisitions as the best path forward. Recent well known examples include IBM’s purchase of Red Hat and Disney’s acquisition of Fox.

These recent events got me thinking about the broader question of whether acquisitions generally enhance shareholder value. Warren Buffet certainly has a strong history of making profitable acquisitions. But the track record of merger failures is long and includes such notable train wrecks as the Kmart and Sears tie-up and Bank of America’s purchase of Countrywide back in the midst of the financial crisis.

Corporate mergers are on average more likely to fail than marriages. In a recent study of North American acquisitions, KPMG found that only about one-third of mergers, acquisitions and takeovers add value while almost 70% actually reduce shareholder worth, or at best are neutral.

NY Stern School Professor Aswath Damodaran finds that acquiring firms tend to overpay for target firms. This outcome, often referred to as “the winner’s curse” is particularly likely in hotly contested auctions where, due to incomplete information and emotion, bidders have a difficult time determining a target’s true worth. Managers, he claims, also tend to overestimate the value associated with synergies and enhanced control. Finally, there is the issue of execution. Combining two distinct cultures to say nothing of processes and products can be a daunting challenge and one that is often underestimated by acquiring firms.

So if mergers have such a poor track record, why do they persist? Damodaran points out that the very nature of the deal process is partly to blame. Consider first that the compensation of a number of key players (investment bankers, accountants etc) is based on whether the deal closes, not on whether the deal is a long - term success for shareholders. Second, managers complete deals with shareholder money. If managers’ interests (read compensation) are not aligned with shareholders’, then funds may be misspent. Boards of Directors, tasked with the role of protecting shareholder interests, have too often been an ineffective check on management aspirations. Finally, the “fairness opinion,” which typically blesses deal prices and is required as a condition of sale, can also be subject to conflicts of interests.

Investors can draw several important conclusions from this research. First, thanks to the winner’s curse, losing in a competitive bidding process is often a good thing (see chart below.) Acquisitions where there is one sole bidder are less likely to lead to overpayment. Small acquisitions of private firms in general tend to produce better outcomes than those involving large public companies, and mergers where the chief focus is on reducing costs rather than growing revenues generally produce better results. Watch out too for firms that undertake acquisitions simply as a way to either keep up with the rest of the industry or get out of a bad business.

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Finally, it is important to remember that we can never tell exactly how things are going to turn out. Consider the $165 billion acquisition of Time Warner by AOL, widely considered the worst business combination of all time. Back in 2001, AOL ruled the internet. But over the next five years the rapid rise of cheaper and faster broadband service decimated AOL’s fortunes. Things got so bad that in 2006, the firm retired its name. Ultimately, AOL was acquired by Verizon for a mere $4.4 billion. And Time Warner? AT&T picked it up this past spring for $85.4 billion.