Merger Waves: Pharma, Telecom and the Scramble for Position

We've talked about merger waves many times in these posts.  In general, some catalyst produces shocks in an industry and creates opportunities (and sometimes necessities) for consolidation.  The shock can be a change in technology, consumer tastes, regulation or any other shock that alters the costs or benefits of acquisition.  

In the current environment, Telecom and Pharma represent merger waves with multiple parties scrambling for position.  Let's consider Pharma: The Pharma wave has been under way for quite some time.  As far back as 2009 we saw the mergers of Merck/Schering-Plough, Pfizer/Wyeth and Roche/Genetech.  We continue today with deals by players such as Sun Pharmaceuticals and Bayer.
Among the catalysts for Pharma are the exploration of patents as companies search for new sources of growth, and the realization that some of the large R&D expenditures of the past haven't paid off.

For Telecom the catalysts include deregulation and dramatic changes in technology including increased use (and uses) of hand held devices, tablets, and smart phones.

As rivals combine, the competitive landscape in any industry changes and firms scramble to maintain viability.  In today's market many deals in Pharma and elsewhere remind some of the heyday of 2007 with high multiples as too many bidders search for too few deals.  

Indeed, there is empirical support for different valuations at different stages of a merger cycle.  Harford (2005), for example, notes that bids later in a wave cycle are associated with lower returns.  This makes practical sense as well - when a catalyst makes various firms attractive, the low hanging fruit is the first to be acquired.  As attractive targets become scarce, bid prices rise and acquiring returns decline.

Some experts appear unconcerned about the current high multiples, but as Joe has said many times, when they start telling you "this time is different" grab your wallet!  While good deals remain, acquirers must be careful to assess risk and return objectively and only make those deals that are value additive and consistent with a firm's strategy.  It is important to beware of behavioral biases especially when deals are occurring quickly all around you.  Nevertheless,  while markets are efficient, deal makers are human.  Tread carefully,

All the best,

Ralph

Rolls Hubris Hypothesis and Acquiring Firm Returns

I've heard management professors and some consultants throw around comments like "Seventy percent of all acquisitions fail."  I don't believe it and the statistical evidence doesn't support that claim.  True, there is a lot of evidence that suggests bidders break even or lose a few percent at the announcement of a bid.   The combined returns to bidders and targets, appropriately weighted for size, are positive.  The typical deal creates value.   What I might believe is that 70 percent (or more) of mergers fail to realize their potential.  But that is typically a problem of integration and the subject of other posts. 

So what do we make of the continuing story that bidders tend to lose or break even?  After all, bidding activity continues to be quite popular (even if currently dampened).   There are many explanations in the literature to explain bidder returns.  Today, I will mention two.

The first is the possibility that we, as researchers, are not measuring returns correctly.  In a recent paper published in the Review of Financial Studies we present evidence that the typically measured bidder return doesn't adjust for anticipation.   When returns are measured correctly bidder returns are positive.  See (Anticipation, Acquisitions and Bidder Returns.)  

But let's return to the fact that some deals, however measured, do result in the loss of value to the acquiring firm.  Even in our sample this occurs as much as 40% of the time.  Why? A good place to start looking for the answer is in the price paid for the target.  As we have noted, Every deal is a bad deal at some price.  Not every deal is a good deal at some price.

In an efficient market, the value of a firm's shares are priced correctly.  Why would bidders typically add 20-40% to the market price in their bids?  Why would bidders pay more than this? The obvious, and always cited reason is synergies.  Synergies, of course, can be easily overestimated and in other posts we note that you should always challenge the assumption of synergies.  Why are they available to your firm and to no one else?  

Another reason to explain high bid prices is behavioral - the hubris factor. Roll (1986) was the first to point this out in the finance literature.  

Anyone who has bid for an object on Ebay understands that it is easy to overpay, to go beyond the rational limits we might set in advance on our bids.  We get caught up in deal fever or a desire to 'win' regardless of price.  The same behavior must certainly be true of at least some acquiring managments.  One can imagine the psychological pressures on management in certain bidding wars.  Multiple sides express multiple views with many unkind words and suggestions.  If psychological factors lead bidders to go beyond pre-determined boundaries (or equivalently if management directly or indirectly causes their own analysts to overestimate the gains to mergers in setting those boundaries) shareholders lose.  As we have noted, some of the best deals are those not attempted or in this case, not completed.  

One of the best illustrations of the hubris phenomena are found in the words of Warren Buffett, quoted in a previous post,

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently, they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

We'll continue this discussion in two ways in the future.  One will be through an analysis of other factors related to bid premia and to bidding and acquiring returns.  A second avenue of analysis will continue to explore the role of behavioral factors in mergers and acquisitions.

All the best,

Ralph 

Beware the Winner's Curse

Many acquisitions fail to create value for the acquirer and in most deals, the benefits go largely to the seller. This reflects the highly competitive nature of the M&A market. It also reflects the large concentrated investment bet at premium prices of M&A transactions. Buyers, in effect, are pre paying for uncertain future revenue and cost synergies. Frequently, buyers over pay for the expected synergies based on managerial optimism, overconfidence and the urge to beat competing bidders.  So it is understandable that the buyer’s shareholders react negatively to acquisition announcements. Many studies indicate that, on average, the acquirer’s share price falls once the transaction becomes public. (For alternative evidence see Ralph's blog on Anticipation). This overpaying is known as the winner’s curse or hubris-when the winning bid in an auction exceeds the target’s value. The absolute dollar loss of acquisition can be huge.  The loss can be estimated by looking at the level of goodwill paid and its subsequent write-off. Goodwill, the amount of the purchase price exceeding the target’s book value, represents a crude measure of over payment. Duff & Phelps estimates the amount of goodwill write offs, a proxy for overpayments which failed to materialize, for the 2007-2011 period to exceed $325B.

The key to avoiding this problem is to make an accurate assessment of the target’s value and to have the discipline not to bid more than that value. This requires establishing a walk-away, or reservation price, before making a bid.  The opening bid should be set at a fraction of that price based on competitive considerations. Ultimately, it is not just what you buy, but what you pay that determines an acquisition’s success. Overpaying for benefits received destroys acquirer shareholder value.

Distinguishing between cheap and frugal is needed when pricing an acquisition. Cheap refers to low value. Frugal, however, represents efficiency. You usually get what you pay for. Equally important is to avoid over paying for what you get. Complicating this matter is that price is fact, representing what the buyer gives up immediately. Value is an opinion concerning what you expect to receive in the future.

A target’s price has two components.  The first is the stand-alone, pre-bid minority ownership price.  It reflects the status quo value of its cash flow under the current strategy and management.  The second is the premium required to persuade the target’s shareholders to sell a control position.  The premium can be estimated from comparable transactions and can vary widely over time, reflecting the economic cycle.

Expected value includes the target’s status quo value plus potential synergy improvements. Value varies by owner depending on strategies pursued and execution of that strategy.  The acquirer’s net value added equals the difference between the expected synergies less the premium paid to acquire them. Buyers lose when the transaction premium exceeds the expected synergies. Thus, the buyer’s maximum price should be less than the seller’s status quo value plus expected synergies.

Projected synergies can represent a form of valuation Viagra used to justify excessive premiums.  As Warren Buffett notes, while deals often fail in practice, they never fail in projections. Buffett continues by noting that any business craving of the leader, however foolish, will be quickly supported by detailed rate of return and strategic studies. Avoiding this trap requires strong board of director oversight. Firms with weak governance and dominated by forceful CEOs are prone to the winner’s curse.

The board needs to consider the risk of an acquisition represented by the shareholder value at risk (SVAR), which represents the premium offered relative to the buyer’s market capitalization.  It measures the impact of failing to achieve the projected synergies. Larger, more competitively priced transaction with high SVAR should receive additional oversight.

Value additive acquisitions are difficult. Growth is not free. Furthermore, acquisitions are subject to behavioral biases like the winner’s curse that frequently override good analysis. Buyers need to exercise pricing discipline based on strong board oversight. There is no right way to do the wrong thing. Overpaying for synergies with an excessive premium is the wrong thing.  Bid wisely to avoid the winner’s curse. Keep in mind that bad bidders make good targets.

Joe

Acquisition Returns and Unresponsive Toads

Financial academics have been analyzing mergers in a scientific fashion for over 30 years.  One thing that has always puzzled me about this research is the accepted result that bidding firms either break even from acquisitions or lose a few percent on the deals they make.  (This tendency,  incidentally, helps explain one arbitrage strategy in stock deals, buy the target and short the bidder.)

But accepting this result doesn't tell us why bidders would undertake such deals.  Many explanations have been given.  Until recently, the arguments that seemed most plausible were a) that returns were driven down by competition for the target (bidding wars) or b) that the bidding firms get carried away with their own power - believing that they are endowed with greater abilities to manage a target.  Obviously, these two items are related.  The difference is that the explanation under (a) still allows for bidders making profitable deals.  Explanation (b) implies overpaying.

On Monday, I'll present new evidence from research we have conducted showing that bidders do indeed earn significantly positive abnormal returns when deals are announced - we just have to measure them correctly.  But our results don't imply that explanations (a) or (b) are incorrect.  All three explanations can and probably do hold water.  Competition does drive down returns, and while the typical deal is profitable when measured correctly, many deals lose money for bidders.

So today, I focus on the hubris explanation.  This idea was  first mentioned in the academic literature by Richard Roll in 1986 but I conclude with a non-academic and more entertaining analysis of the issue - a quote from Warren Buffett.


"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

On Monday - what impacts returns to acquiring firms and how to measure them more accurately.

Have a great weekend,

Ralph