Wednesday, September 12, 2012

It is What You Pay- Not Just What You Buy-That Matters

Corporate profits are strong. Macro uncertainty is high and reinvestment rates are muted. Consequently firms are holding record levels of cash. Managers cannot wait for the last black swan to land before deploying their cash. Nonetheless, organic growth is difficult in the current environment. Acquisitions can be a valuable supplemental growth option. Acquisitions, however, are risky. Much research indicates that the typical acquisition fails to create value for the buyer's shareholders. Buyers can succeed despite the odds if they are disciplined-especially about price.

Pricing-over paying for an acquisition- is the single biggest risk. Even the prefect target becomes bad at some price. The key is to avoid paying more than the value received. Price is a fact. It is what you give up immediately. It reflects the target's standalone value plus a premium. Value is an opinion of what you hope to receive over time represented by the standalone value plus synergies. Therefore, the target's net value added is the premium less expected synergies. The iron law of acquisitions is the buyer's shareholders lose whenever the premium exceeds synergies. Sounds simple, but is complicated by two factors.

The first is the winner's curse. In a competitive market, and the M&A market is highly competitive, the winning bidder tends to over estimate the target's value. The second is what Warren Buffett calls the institutional imperative. Essentially, whatever the CEO wants will be supported by extensive projections and numerous strategic studies. That is why it is critical to establish a reservation or walk away price before the bidding begins to avoid getting carried away during the heat of the battle. This reservation price should be set below the target's estimated net value added. Keep in mind there is no one true intrinsic value. It depends on the buyer's strategy and ability to execute on that strategy. Certain acquirers employing higher value added strategies can extract higher values from an acquisition. They will- in effect- be the natural owner of the targets, and can successfully out bid other interested parties. You need to identify those unique factors allowing you to "win" the bidding and still create value for your shareholders to avoid the winner's curse.

Successful acquisitions are difficult-not hopeless. You need to recognize this fact, and maintain a strong sense of humility. This means keeping your confidence to competence ratio below one. Remember there is no right way to do the wrong thing. If you over pay relative to the target's reasonable expected synergies, then you become a bad bidder. Bad bidders become good targets. So let the buyers beware.

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