Here We Go Again?

The best of deals are made in the worst of times while the worst deals are made in the best of times. We may be seeing a replay of this mantra in the current M&A market. Coming off a deep post crash low, M&A activity has sharply rebounded. This reflects a recovering economy, booming capital markets and rising managerial and investor optimism. The activity is driven by strategic buyers instead of private equity. The number of large deals over $5B has also increased. Larger deals are froth with danger given the potential to over pay and heightened integration problems associated with larger deals. The buyer’s shareholders usually react negatively to the announcement of such deals-and for good reason. Their track record underlies this reaction; namely, 50% of targets are disposed of within 10 years of the closing.

Yet, such deals are now receiving a largely positive response from the buyer’s shareholders. Some possible explanations for this development include:

1)     Buyers are getting better at making acquisitions (AKA this time is different).I have seen no evidence to support this possibility.

2)     We are early in economic and M&A cycles. Thus as the cycle continues we will see mean reversion.

3)     Shareholders are confusing size and growth with value creation.

My concern is a toxic brew may be developing. This brew includes investor bias towards growth combined with managerial overconfidence. Board selection of CEOs favors over confident CEOs who are viewed as decisive optimists. The process favors the lucky risk taker with a “successful” track record -think of past Hewlett Packard CEOs Carly Fiorina and Leo Apotheker who both engineered disastrous acquisitions.

So what can boards do to prevent future over priced ill conceived acquisition disasters? It is unlikely subordinates will question CEO’s who want to do the deal. What is needed is a strong experienced lead independent director who can challenge-not second guess- large scale transactions by considering the following:

1)     Does due diligence support the deal’s thesis?

2)     Is there a detailed integration plan based on the strategic rationale of the deal?

3)     Have competitor responses been considered?

4)     How will changing economic and industry conditions impact deal economics?

5)     Are CEO incentives tied to the success of the acquisition?

The real key is to run alternative stress case projection scenarios reflecting what could go wrong not just what is expected. A useful approach is to consider what could cause your deal to fail financially in the next few years. If you cannot think of any - then think again - they are out there.

J

Valuation in M&A - Reports from the Field

In teaching finance to MBAs, I stress an analytical approach to decision making and strive to give the students the latest tools of our field and to discuss the latest empirical and theoretical research.  But I also stress that 'People Make Decisions', not algorithms or analytical techniques.  Also, it is people who implement decisions.  Certainly, this is crucial in the field of mergers where integration remains one of the major concerns.  Finally, I note that there is an Art and a Science to finance.  We can teach the science, but the art is nuanced and requires a great intuitive grasp of the subject blended with experience.

Here is an interesting article on how practitioners are actually valuing companies in M&A transactions.  It makes the same points.  The authors interviewed investment bankers who confirm use of the techniques often discussed in these posts: discounted cash flow and comparable transactions.  The article also highlights the use of judgement in making these decisions, noting:

"While leading practitioners routinely use DCF methods in mergers and acquisitions (M&A) valuations, the application is often far from “routine”; it requires art and judgment in the face of inherently uncertain business forecasts such as those surrounding merger synergies. Our results serve as yet another reminder that analytic techniques such as DCF do not make decisions but only inform them."

From "Company Valuation in Mergers and Acquisitions: How is Discounted Cash Flow Applied by Leading Practitioners? by W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins"

All the best,

Ralph

M&A Red Flags

It may be useful to review some M&A red flags as the M&A market continues to improve. These signals are frequently ignored once the deal process starts. My on-going list is as follows:

1)    Do you believe in magic? Aggressive revenue based synergies are always questionable. Failure to consider competitor response to revenue gains renders the estimates useless.

2)    It is a great target: It may be, but it is still a bad acquisition if you overpay. For me, premiums greater than 40% over the pre bid target stock price are delusional.

3)    Trust me: New CEOs still in their honeymoon period can get some strange deals approved.

4)    Trying to get my mo-jo back: Underperforming firms seeking to regain their old growth status usually violate the first law of holes-when you are in a hole-stop digging. Such firms are not the best owner of the target’s assets and make the acquisition for the wrong reasons i.e. weak strategic rationale.

5)    Bid’em up: Revising upward your pre bid walk away price once the bidding begins. Frequently based on some newly discovered synergy, but always fatal.

6)    Don’t worry about it: Large transformational trophy deals with high levels of shareholder value at risk (SVAR). SVAR is the premium expressed as a % of the acquirer’s pre bid market value. Sometimes known as the “bet your company” acquisition strategy.

7)    What- me worry?  Coupling a large high business risk acquisition with a highly leveraged capital structure is questionable. Flexibility is needed to successfully implement the acquisition and withstand possible competitor responses.

8)    All the other kids have one: Late cycle acquisitions to catch up with peers.

9)    It has to work: Vague existential integration plans.

10)  Don’t confuse me with the facts: Weak or ignored due diligence.

11)  Tunnel vision: Ignoring alternatives such as doing nothing or selling out.

12)  We can trust them: Dealing with sellers who have questionable motives is always dangerous. Make sure you listen to your lawyers by including risk mitigation clauses in your documentation. If the seller objects-ask why.

The presence of any one of the above should be a cause of concern for investors and directors. Two or more should be enough to reject the transaction.

Good hunting, but be careful-it is dangerous out there.

J

Merger of Equals: A Really Bad Idea?

Last month advertising firms Publicis Groupe (PUG) of France and U.S. based Omnicon (OMC) announced a $35B MOE Merger creating the world’s largest advertising firm .The initial market response was positive with Publicis up 6% while Omnicon increased 7.7%. Synergies of $500MM are expected.

The new firm, Publicis Omnicon Group (POG), will be based in both NYC and Paris. POG will have 14 board members - 7 each from PUG and OMC. POG’s CEO and OMC’s CEO will serve as CO-CEOs of the new combined firm for 30 months. Then OMC CEO will then become CEO as PUG’s Levy is set to step down and become Chairman.

MOE share the following characteristics:

1)     Similar sized firms in the same industry

2)     Substantial portion of the new combined firm is held by each firm’s former

        shareholders

3)     Limited or no premium paid

4)     Stock swap using fixed exchange ratio usually with no caps/floors

5)     Sharing of governance between the two former firms-Co Equal CEOs, etc.

Point # 5 is the issue which causes the most danger in successfully implementing a MOE despite their low premium. The Co Equal structure complicates cultural integration and execution making it difficult to realize the promised synergies. M&A already is a risky activity without adding an additional layer of integration barriers. This is why MOE have a checkered record including:

1)     Daimler-Chrysler

2)     Alcatel-Lucent

3)     Citi-Travelers

4)     Morgan Stanley-Discover

5)     First Union-Wachovia

The integration issues are especially acute when the firms have different business models (e.g. Citi-Travelers) and cultures (e.g. Alcatel-Lucent).This is critical for POG regarding client conflict resolution. For example, Coke is a Publicis client while Pepsi is an Omnicon client. How do you do what is best for the client without upsetting either the Publicis or Omnicom account managers? Another issue is handling the different compensation systems - a U.S. style Omnicon and a Euro Publicis without alienating employees.

Typically, MOE are more symbolic than substantive. They are used get approval for a combinations that otherwise would not occur. For example, General Mills had to incorporate a complex governance sharing structure into its Yoplait yogurt acquisition to get French approval. Usually in a MOE, some parties turn out to be more equal than others.

The basic problem with MOEs is they work in theory but not in practice. The numbers seem to work, but the “soft” issues- people, governance and integration frequently do not work once the deal is closed. You can try to let the lawyers work it out with a detailed memorandum of understanding covering items such as:

 1)     Governance: board size, composition, key committees, management team

         compensation, and management succession.

 2)     Surviving name and HQ Location

 3)     Strategic Plan and Direction

 4)     Capital Structure, Ratings Target and Dividend Policy

 5)     Who Will Be the CFO and What IT Systems Will Be Used

 6)     Professionals: who will be the surviving accountant, lawyers, investment

         bankers, etc.?

 7)     Due Diligence

 8)     Identification and Retention of Key Staff

 9)     Investors Relations Strategy

10)    Detailed Integration and 100 Day Plans

The problem with the lawyer approach is that it inhibits flexibility needed to integrate the two firms. The focus on fairness and balance can interfere with making the right business decision. This can lead to frustration and conflict. The danger is this creates an “us v them” mentality leading to in-fighting. Remember, the two firms were formerly rivals. Thus, some bad blood among the staff is likely to exist. This may make it difficult for them to get along in any event.

I wish the Publicis and Omnicom combination the best of luck. My gut tells me this is going to be a bumpy ride. Co-CEOs and dual HQs, especially with organizations having such different cultures (French v American) raise the odds of a disappointing integration.

j

Synergies and Anticipating the Competition

  Today's post continues the discussion of the 14 Keys to Acquisition Success that we posted in early September.  We are actually combining points five through nine in that earlier post.

5.   Beware of unrealistic projections.  Understand the source of synergies.  Why are these synergies available to you and not other buyers?

6.     Beware the winners curse – you win the auction not because you are the smartest, but because – you paid the highest price.

7.     Most deals fail to reach their full potential because of issues in integration. Don’t underestimate the costs and problems of integration.

8.     In mergers, 2+2 can equal 5, (3 is also a distinct possibility)!

9.     Think strategically, but understand that your competition is doing the same.

Mergers can be wonderful opportunities for value creation through synergies.  But synergies can also be negative (point 8).  When that happens it is usually because of unrealistic projections on the front end, inadequate due diligence, or poor integration (point 7).  Destruction of value also occurs when bidders overpay and Joe and I have warned repeatedly about hubris and the winner's curse (point 6).  That is, you 'won' the deal not because it creates value but because - you paid the most for it.  And given a world of smart, competitive bidders, this likely means you won not because you were smarter than the other bright lights in the room, but simply because you were willing to pay the most.  

But synergies do occur and mergers on average, create wealth for the target shareholders and even for the combination of target/bidder shareholders.  So how do you know where to look for synergies and how do you avoid overestimation?  The key is to look for your own sustainable, competitive advantage.  What is it that your company can do better than anyone else in the near future?  The point about the near future gets at the sustainable part.  Having a sustainable advantage in the long run, is of course, even better - but in the long run, most strategies and abilities can be copied or learned or acquired.

So we have to continually ask ourselves:  where do these synergies come from?  And, at least as important - why is no one else able to achieve the same synergies?  What is it that makes them unique between our firm and the firm we are acquiring.  Remember that if the synergies were not unique to our firm, it is likely that other firms would be bidding as well.

Finally, and related to all of the above - think strategically.  It is simply not good enough to anticipate your next moves or acquisitions assuming that the status quo in your industry is maintained.  There is a tendency to project our cash flows assuming our competitors are not also anticipating and adapting to the future.  So think strategically, but understand that your competition is doing the same (point 9).

All the best,

Ralph