Thursday, February 28, 2013

Merger Motives

It has been said that there are as many motives for mergers as there are mergers.  While each merger is certainly unique, there are certainly common themes.  That said, a very partial (top of the head) list of (non-mutually exclusive) motives would include:

  • Synergies
  • Tax strategies
  • Market share
  • Eliminating a competitor
  • Expanding geographically
  • Expanding the product line
  • Acquiring Technology (ex. patents)
  • Utilizing management skills
  • Acquiring management skills
  • Merging defensively - (to prevent a competitor from doing the deal and getting an advantage)
  • Regulatory reasons
  • Strategic plans
  • Acquiring an undervalued firm
  • Acquiring a supplier or customer to improve quality/costs
  • Eliminate redundancy (two CFOs, etc.)
  • Take advantage of economies of scale 
  • Improve product distribution
  • Corporate diversification
  • Increasing debt capacity


There are several things to note about this list.  First, it can go on and on.  Indeed, in working with teams of executives I've frequently challenged each individual to come up with a motive for merger than hasn't been mentioned by one of their colleagues.  We can generally go to 20-30 motives before we start repeating and even then someone will mention a new idea. But as we go forward most ideas start to be nuances (subtle or blunt) of previous ideas.  

That is certainly the case with the brief list above.  So Second, the motives are overlapping.  For example, 'eliminating redundancies' and 'taking advantage of economies of scale' are both related and both can be considered as subcategories of 'synergies'. 

Third, there are two broad types of motives.  The first would be those motives related to shareholder wealth maximization.  Arguably, each of the motives listed above are rational attempts by management to improve shareholder value.  In practice, however, even well intentioned motives can lead to shareholder losses.  The distribution and reasons for those losses will be explored in future posts.  

But there is a second broad category of merger motives, not explicitly shown above: managerial motives.  These include:

  • Empire building
  • Acquiring to avoid being acquired
  • Paying too much to get the deal done
  • Hubris
  • Overconfidence
  • Merging to trigger golden parachutes
Empire building means expanding the size regardless of wealth effects and often falls under the guises of the earlier mentioned list of motives. Acquiring to avoid being acquired can be good or bad for shareholders.  If good (perhaps due to market misvaluation due to information asymmetry about the firm’s growth prospects between management and investors), shareholder wealth improves.  If bad (such as to preserve executive jobs) shareholder wealth declines.  Naturally, whether it is good or bad is arbitrated by management. Paying too much to get the deal done happens when executives get caught up in deal fever and overpay to win the deal.  (See our related posts on the Winner's Curse and AnyDeal is a Bad Deal at some price.)

Be careful with mergers – challenge all assumptions.  Ask why the same result cannot be achieved with internal growth.  Ask why any projected synergies are available.  Worry about the winner’s cures.  The moral of the story is that successful executives should think like the shareholders.  After all, they are the owners - it is their money being invested - or wasted.  

We'll follow up down the road with two related posts: catalysts for merger and merger waves.  In those posts we'll talk about the various factors that cause a firm - or an industry - to be in play.  We'll also look at the governance measures that can lead to better merger outcomes.  

All the best,


PS Thanks to Joe and also Adam Yore and Jan Jindra for helpful comments on an earlier draft of this post.

Monday, February 25, 2013


M&A volume is on a tear at double the level for the same period last year for the first two months of 2013. There are a variety of reasons underlying that development including an improving economy and favorable financing conditions. Another largely unnoticed factor will further support the increase. Private equity firms raised record commitments for new funds formed in the 2006/2008 boom period prior to the financial crisis. Of the $700B+ raised during that period only half is invested, leaving a large amount of dry powder. The crisis caused funding to dry up and sponsors curtailed their activity during the 2009/2011 period. Most funds contain a provision limiting the time of the fund to invest to 5 years. Many of these sponsors are now facing the end of their 5 year investment period over the next 6-18 months. Commitments not invested by the end of that period expire - use it or loss it. It is estimated that almost 100B of this dry powder will expire this year alone. The loss of the commitments reduces their fee income. This can be problematic for the continued operation of many funds.

A further complication is the same difficult financing market conditions that limited their investment activities also depressed their ability to exit prior investments. Consequently, the average age of their portfolio investments now exceeds a record 5+ years. Unlike fine wine and cheese, portfolio investments do not age well. Their advancing age means investment returns (IRRs) are falling. Some large funds sponsored by well-known firms raised during the boom period register IRRs below 3%.

This complicates covering the requirement in most funds that a preferred return or hurdle rate, usually around 8%, be achieved before the fund general partners can receive their carried interest. Carried interest is the share of the gain, usually 20%, the general partners receive of any gains once an investment is sold. Thus, general partners are more reliant on fees on funds invested than carried interest.

This background suggests private equity firms will leave no stone unturned as they search for investments to make sure they fully deploy all commitments prior to the end of their investment period. This creates a potential conflict between the general partner fund managers and their limited partner investors. Therefore, we can expect to see an increase in questionable deals, especially in two areas.

The first is sponsor-to sponsor or secondary buyouts. These involve firms purchased by one PE firm and subsequently sold to another. Secondary buyouts, sometimes known as pass-the–parcel deals, now exceed the value of first time buyouts for the first time. These transactions are deemed lower quality for two reasons. First, it is difficult to squeeze additional improvements from firms that have already gone through the LBO process. Next, they raise the issue of collusion between PE firms to manufacture exits and create IRRs: buy my deals at favorable prices and I’ll buy yours. Next, mega deals, like Dell and Heinz, will become more popular to deploy funds quickly - perhaps too quickly.

The amount of dry powder, combined with the current leverage level of 30-40% equity, can support a huge amount of LBO transactions.  Consequently, we can expected the level of LBOs as a percentage of total M&A to increase from their current 10% level to pre-crisis 30% levels. Unfortunately, given the incentives, many of these deals may have a difficult ending. The noise of the ticking investment period clock may adversely influence the judgment of many PE firms.


Friday, February 22, 2013

Social Terms in Mergers, US Air, American, Office Max and Office Depot

We've noted before on this blog the importance of negotiating on all aspects of the deal, not just price. (See, The Interrelated Nature of Deal Design.) The recently announced  mergers of US Air and American Airlines and also Office Max and Office Depot  are good examples of the importance of social terms.  

Social terms include things like the name of the merged firm, where it will be headquartered, who will be the CEO and how the board of directors will be constructed.

Consider the US Air - American Airlines merger.  Although US Air pursued this deal vigorously and is the acquiring firm, the combination retains American's name and will remain headquartered at its Fort Worth location.  Doug Parker, CEO and Chairman of US Air becomes CEO and board member of the new firm and after one year, Chairman of the Board.  Thomas Horton, Chairman, President and CEO of American Airlines will be Chairman of the Board for only one year.  

The Board of Directors of the combined firm will consist of 12 members, three from American Airlines,   four from US Air, and five from the creditors of American Airlines.   I'm a bit surprised that US Air doesn't dominate the board.   

Think that board composition isn't important?  Recall the merger of Duke Energy and Progress Energy that closed in July 2012.  Bill Johnson, the former CEO of Progress was to be CEO of the new firm, but was fired within 24 hours.  Replacing him was Jim Rodgers, the former CEO of Duke.  Under the merger terms, Rodgers was supposed to have been Chairman of the Board.  Reportedly, both of these CEOs had suffered errors in their stewardship as CEO.  Why did Rodgers survive?  One possibility has to do with board composition: the combined firm had 18 board seats, 11 from Rodger's Duke Energy and 7 from Johnson's Progress Energy.  

And then there is the merger of Office Max and Office Depot announced yesterday.  According to the announcement (which was, incidentally inadvertently leaked on Wednesday) the name and headquarters will be announced after the company appoints a CEO?

Huh?  Social terms are important components of any deal determined in the give and take of normal negotiations.  And social terms are costly - they involve real changes with real economic effects.  But not knowing the social terms?  That, would seem to be even more costly.  Not knowing these items as a deal is announced does not seem like the start of a prudent, coherent strategy.  Integration is fraught with uncertainty in the best of deals.  Starting out without  knowing the basic game-plan can only increase integration costs.  
Knowing your social terms? Important.  

Not knowing your board (if you are a new CEO)?  Courageous or some other adjective. 
Not knowing your CEO or name or headquarters? 

Priceless.  (Not.)

Just a thought,


Wednesday, February 20, 2013

Doing a (Large) Deal? Expect to Get Sued

 A recent working paper by Matthew D. Cain  and Steven M. Davidoff entitled Takeover Litigation in 2012 provides some interesting statistics about the rise in merger related litigation.  Their Table A, reproduced below reveals a dramatic increase in litigation over the past eight years.  In particular, about 39% of deals involved litigation in 2005, while close to 92% involved litigation in 2012.

Table A: Litigation rates over time 
Deals # Litigation           % Litigation
2005 183 72 39.30%
2006 232 99 42.70%
2007 249 97 39.00%
2008 104 50 48.10%
2009 73 62 84.90%
2010 150 131 87.30%
2011 128 117 91.40%
2012 84 77 91.70%
Total 1,203 705 58.60%

Thus, the probability of being sued in a merger is over 90%.  Keep in mind, however, that the size limitation on their sample is deals over 100 million.  The percentage would undoubtedly be smaller for smaller deals.  Also, as my friend Jan Jindra notes: "The result is, perhaps, not surprising, when private plaintiff attorneys are allowed to initiate class action lawsuits in names of nominal shareholder plaintiffs and finding a willing shareholder plaintiff is made easy and cost-efficient through the use of law firm internet websites. Rational economic agents, attorneys, find that filing a class action lawsuit circumvents the constraints imposed on derivative suits which are designed to limit opportunistic “strike” suits. Furthermore, ready availability of websites by law firms actively recruiting shareholders who have been involved in a merger helps in finding a shareholder plaintiff." See for example the website linked here. "These two ingredients make an increase in merger lawsuits likely."
Certainly there are adequate reasons to have concerns about certain mergers and we've enumerated many in these posts.  Concern over the 'kneejerk' reaction of filing a lawsuit, however, is revealed in "Cash for lawyers - zero for you".  The article reports that over 70% of lawsuits resulted in no payment to shareholders. 

Regardless of the merit of the litigations, the actions definitely increase the costs of mergers. They also increase the need for best practices in corporate governance and in planning and executing the deal.  We'll continue to explore these issues in this blog.



Monday, February 18, 2013

2013 - Year of the Deal or Year of the Snake?

A rash of deal activity, especially larger deals, has occurred this month with the Dell, Heinz and Comcast announcements. This increase, which actually started in 4Q12, if sustained, could see 2013 deal flow reach a post crisis level not seen since the credit crisis. Care is needed in M&A predictions, however, as a rebound has been projected for the past several years. This time, the rebound seems likely to last for the following reasons:

1.     Reduced, albeit still significant, macro political and economic uncertainty.

2.     Significant pent-up demand given years of depressed activity.

3.     Pent-up need for consolidating M&A in several industries including tech, consumer products and banking to offset growth and margin pressures.

4.     Improved financing conditions. Bankers and investors, in general, are searching for yield in a low return environment given their improved financial condition following massive credit crisis losses. The focus has shifted to return on capital instead of return of capital. Consequently, the return of cheap and plentiful financial capacity to fund the $23B Heinz LBO at an aggressive 6X funded debt to EBITDA level.

5.     The stock market has finally recouped its crisis related losses after 5 years. M&A and the stock market are both reflections of investor confidence.

6.     Corporate balance sheets and earnings remain robust. Hence, deal and debt capacity are strong and permits larger deals.

7.     Investor reaction to recent announcements has been unusually positive. Buyer shareholders are suspicious of M&A announcement given the propensity to over pay. Thus, buyer stock prices frequently decline. Current deals, occurring earlier in the cycle, appear to have lower price risk and better strategic rationale than deals in general. Therefore, buyer’s share prices have actually increased following the deal announcements. This will not go unnoticed by other potential buyers. Of course, the potential for an over-priced HP-Autonomy deal is never more than a click away.

8.     Momentum feeds on itself. A combination of confident buyers combined with liquidity provided by yield seeking investors will support a herding effect which can last for a considerable period.

The most likely result is an upturn in the M&A cycle which builds over the next few years. The speed and magnitude of the rebound are unknown. As in previous cycles, the best (i.e. reasonably priced) deals are made earlier in the process. It appears 2013 may actually be the real deal. This is good news indeed for revenue starved advisors, banks and investors at least in the short run.