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

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

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.