Friday, October 5, 2012

Any Deal is a Bad Deal at Some Price; Not Every Deal is a Good Deal at Some Price

We promised to return to the post entitled "14 Keys to Acquisition Success" and elaborate on one of the keys each week.  Today we look at Key 2:

2.     Any deal is a bad deal at some price; not every deal is a good deal at some price.

The first part of the statement is pure math.  Acquisitions are capital budgeting decisions.  We estimate the cash flows we think we can receive from a potential target and discount those cash flows to the present.  The sum total of these discounted cash flows is our estimate of what the deal is worth.  If we can acquire the firm for less than this our estimated net present value is positive and the deal looks good - it increases our value. When the costs exceed the benefit, the NPV is negative and should be avoided.  

We've written earlier about two behavioral problems with this math.  First, the present value amounts are estimated and can be subject to conscious or unconscious adjustments to justify an acquisition.  Second, even if the value is estimated correctly, potential acquirers can get caught up in bidding wars that escalate the price beyond what it is worth until the firm is acquired - at a loss to the bidding firm's shareholders.

The last part of the phrase is not as obvious.  Doesn't it follow that every deal becomes a good deal at some price?  No.  The reason for this is that the estimated cash flows from a deal can actually be negative once all the costs of integration are considered.  Thus - even a zero price could produce a loss.  (This assumes, of course that one cannot buy the firm and flip it to another buyer at a higher price - in that case, the estimated cash flows would be positive).  Note, it is not hard to find examples of deals that are examples of the principal or at least come close.  Think Sprint/Nextel or AOL/Time Warner or Quaker Oats/Snapple.  In the latter case, Quaker bought Snapple in 1994 for 1.7 billion and was forced to sell it a little over two years later for 300 million.  

Of course, there is much to be said about how cash flows are estimated in the first place.  We'll just note four points for now.  First is the importance of starting with a strategic question: is the acquisition a good fit?  Second is adequate consideration of all of the components that go into cash flow.  On the negative side this includes integration costs (part of which is an allowance for disruption in management during the transition).  On the plus side it means recognizing that cash flows could extend beyond those of the particular deal to new opportunities the project creates.  These are the 'real options' associated with the acquisition.  For example, acquiring a firm in Singapore may look like a zero net present value venture.  But if that venture is successful, it could give you access to the entire South East Asia Market which could be quite profitable.  (Note: be very careful with real options.  They can be quite important, but can easily be manipulated to justify deals.)  Third is the importance of justifying any synergistic cash flows - understanding the source of these synergies and the reasons these synergies accrue to your firm and are not bid away by competition.  This frank analysis will help, but not prevent, your overestimating cash flows.  Fourth is the need to use the proper discount rate - one commensurate with the risk.   

There is much more to the estimation process, but this covers some of the basics.  The point is: any deal is a bad deal at some price but not every deal is a good deal - even if the price were zero.


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