August 1, 2007
Key Issues for an Accretive Transaction:
Purchase Price
Integration Management
Financing Structure
Target Company Status
Earnings Growth
Focused versus Diversifying Acquisitions
The key issue in any M&A transaction is whether the transaction is likely to create value for the shareholders of the acquiring firm. Does the act of purchasing the company increase the value of the acquiring company? Does the acquirer’s stock outperform its peers in the long run? In looking at several studies that have investigated whether acquisitions create value and the prevailing view is while the target shareholders generally fare “pretty well”, but most acquisitions fail to create accretive value for the acquirers. Historically, within the U.S. only 30% of all mergers create value for the acquirer. Further, there is huge variation in acquisition outcomes, from very positive to very negative, which suggests that actual acquisition integration execution may play a significant role in creating value.
According to the Journal of Applied Corporate Finance, distribution of long-term, industry-adjusted acquirer excess returns was similar to the distribution observed for short-term returns in that there was substantial variability—one-fifth of the transactions generated industry-adjusted returns below –40% and another one-fifth generate returns in excess of +40%. Clearly, some acquisitions created tremendous shareholder value while others were highly destructive. I attempted to distinguish types of factors create substantial value from types that do not. Which factors matter?
The manner in which an acquisition is funded has a large impact on accretive value of the transaction. The research is mostly divides studied transactions into those for which 50% or more of the consideration was in the form of cash (the median transaction in this group was 100% cash financed) and those for which 50% or more of the consideration was in the form of stock (the median transaction in this group was 100% stock financed). The accretive value of the transaction in both the short and long term was more favorable for cash-financed transactions than for stock-financed transactions. Cash transactions had a median short-term value benefit of excess return of 0.9% compared to –1.9% for stock transactions. The difference between cash and stock transactions is accentuated in the long term—over a two year window, cash-financed acquirers outperformed industry peers by 4.3% while stock-financed acquirers underperformed industry peers by 5.2%. Why are stock transactions associated with a lower stock price value? A cash acquisition may send a positive signal to investors about the acquirer’s confidence in its ability to replenish its cash balance.
Further, cash-financed transactions often involve significant debt and the resulting pressure to repay this debt can provide a significant incentive to realize synergies, to closely manage the integration process, and the generally influence of “traditional” debt underwriting.
Target Company Category (Public versus Private; Whole Company versus Asset or Business Unit) - The category of the target is also a primary driver of acquirer returns in both the short and long run. I found that when the target was a private company or an asset or business unit of a public company, transactions were associated with median short-term acquirer value increase of 1.9% and median long term value increase of 4.2%. In contrast, transactions in which the target was a publicly traded company led to short-term returns of –2.3% around the acquisition and an industry-adjusted –4.4% for the following two years.
There are three possible explanations for this pattern. First, acquisitions of whole public companies tend to be broader in scope (moving the acquirer’s core competencies), and thus more prone to complex integration problems, than private or business unit transactions. In the latter, acquirers do not typically end up with the infrastructure and overhead of the seller, which also facilitates post merger integration. Second, is no-brainer - acquisition of public companies typically occur at a premium to an already-established public price. The third possible reason for the large difference in acquisition returns is acquisitions of business units or private companies are typically paid for in cash—and I have already shown that cash transactions have a greater accretive value. This may be because, typically, cash transactions have a lower purchase price.
Earnings Growth - It is sometimes believed that rapidly growing companies are the best takeover targets. I examined how acquirer returns were related to projected long-term EPS growth rates of the target. Since most forecasts are unavailable for individual assets, business units, or private companies, I analyzed only the market value to acquisitions of public targets in this section. The long-term results were broadly consistent with the short-term results; acquirers had higher industry-adjusted returns when the target’s projected earnings-growth rate was low. Why are projected growth rates related to transaction success? One reason seems that companies with low projected growth rates are often in more mature industries. Acquisitions of such companies can increase shareholder value through operational synergies. Further, acquisitions are often the only means by which companies in mature sectors can create value. In contrast, companies with high projected growth rates may be able to maximize value by focusing on their own operations. Another possible explanation is the perception that companies tend to overpay for growth. The data partially support this view. The median takeover premium paid for targets in the highest earnings growth quintile was 10% higher than the median premium in the four remaining quintiles. Mature companies with stable predictable cash flows as well as limited investment opportunities should include more debt in their capital structure, since the discipline that debt often brings outweighs the need for flexibility. Younger companies or companies that face high uncertainty because of vigorous growth or the cyclical nature of their industries should carry less debt, so that they can take advantage of investment opportunities or to deal with negative events.
Focused versus Diversifying Acquisitions - Whether an acquisition is “focused” or “diversifying” also has a material impact on its success. I consider a transaction to be focused if the buyer and the target are in the same S&P industry group, and diversifying otherwise. The short-term value to both types of transactions is similar (median share value for both groups equaled –0.6%, (proving how difficult mergers really are). In the long term, however, acquirers in focused (core competencies) transactions outperformed their industry counterparts by approximately 2% while acquirers in diversifying transactions underperformed their industries by almost 3%. Companies often cite the potential for synergies in costs and revenues as a reason for a merger or acquisition. Focused transactions may be more successful than diversifying transactions because it is easier to realize synergies when buying a company or asset in the same industry. In addition, the stated strategic objectives of same-industry mergers may be easier to articulate and realize than those of mergers across industries. Finally, cultural and social issues are often accentuated in cross-industry transactions, which points to the importance of post-merger integration and execution in determining an acquisition’s success.
Critical issues often burden the deal, creating a new top team, communicating the story behind a merger, and shaping the newly merged companies’ performance culture, among other tasks. These are largely intangible, mostly nontechnical, and often unpredictable; these challenges require a degree of experience and an introspective view of our companies’ core competencies, not typically shared by a hired integration team or lower managers.
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