Acquisition decisions are not like other decisions. In Chapter 1, Denzil and Peter point out that ‘most acquisitions fail’, and these are normally the main words of caution to managers. However, decisions with low success rates are familiar to most managers. Think of new product launches or management appointments or IT investments. Against these comparisons, success rates of 30–50 per cent seem quite normal. So the special feature of acquisitions is not their low success rate. The special feature is that acquisition decisions involve big stakes and small prizes.
In most decisions, such as a new product launch, managers make an investment of a few million and, if the decision succeeds, expect to reap returns five or ten times the investment. Of course, a percentage of the time the investment fails; but the failures are paid for by the successes: one success can usually support three or four failures. With acquisitions the sums are different.
In an acquisition the buyer normally pays full value for the target company plus a premium. In other words the buyer pays the discounted value of all future cash flows from the business, plus 10–50 per cent more. The reason why buyers pay premiums is important to understand. They pay premiums because they are normally in competition with other buyers and because they often need to pay a premium to persuade the seller to sell.
The prize is the value of the business after it has been improved by and integrated with its new owners less the total amount paid to the seller and spent on the deal and integration process. If the premium is 30 per cent, a number that Denzil and Peter consider normal, and the value of the business after it has been improved and integrated is 150 per cent of its value before acquisition, the prize is 20 per cent. In other words, the buyer has spent 130 per cent for a prize of 20 per cent: a decision of big stakes and small prizes.
In this situation – a stake of 130 and a prize of 20 – the successes are unlikely to pay for the failures. One bad decision can lose the buyer 100 which will only be recouped by 5 good decisions. The economics of acquisition decisions are, therefore, very different from the economics of most other decisions that managers get involved in.
It is this problem that I focus on in my teaching of acquisition strategy. How should managers approach a decision where the stakes are big, the prizes are small, there are high degrees of uncertainty about valuations and about integration synergies and the premium a buyer has to pay is driven by the amount competing buyers are willing to pay?
I have distilled my guidance into a number of rules:
At five times during the last century there have been more buyers of companies than sellers. These boom periods – the last two were at the end of the 1980s and 1990s – coincide with unreasonably high stock market prices and hence unrealistically high valuations. Managers who pay with cash during these periods will over pay and commit themselves and their successors to work hard in order to stand still.
The best policy is to avoid acquisitions during acquisition booms. However, some strategies cannot wait until the stock market comes to its senses. These deals should be paid for with shares. If managers use shares to make acquisitions when they think prices are high, they will be buying expensive paper and paying with expensive paper, passing on the overpricing risk to the shareholders of the selling company.
Denzil and Peter make this point in Chapter 1. There is no prize unless the integration plan creates improvements and synergies bigger than the premium. In fact the only time that the prize is likely to be big is when the improvements and synergies are large compared to the value of the company as a stand-alone business. If the improvements and synergies are 100 per cent or 200 per cent, the prize will be large even with a premium of 50 per cent.
There is one exception to this rule – when the target company is selling for a discount. While these situations do exist, buyers should beware of discounts. No price is low enough when buying a business that routinely destroys value.
This is a tough hurdle. But the logic is sound. Since the premium is determined by the price that the next highest bidder is prepared to pay, we should be cautious outbidding someone who can create more improvements and synergies than us. Lets take an example. If we can create synergies of 30 per cent and another company can create synergies of 50 per cent, this other company can afford to pay 20 per cent more than us.
The problem is that neither buyer is able to accurately value the target as a stand-alone business or value the size of the improvements and synergies. This is because both valuations depend on forecasts of the future. This means that we will only win the bidding if we are more than 20 per cent overoptimistic and the rival bidder is realistic or if we are realistic and the rival bidder is more than 20 per cent pessimistic. Since it is hard for us to know whether we are being optimistic or pessimistic and even harder to guess the mindset of the rival bidders, we are better off not outbidding a company that can create more improvements and synergies than us.
The equation is not just:
prize = synergies less premium |
The equation is:
Prize = synergies less premium less learning costs less distraction costs less deal costs |
The less familiar the new business, the higher the learning costs. This is why diversification decisions are less successful than deals in the core business. Learning costs are hard to estimate because they come mainly from the mistakes managers make when they are in unfamiliar markets. In my experience, learning costs are rarely less than 10 per cent and can be as high as 50 per cent of the value of the target company if it is an unfamiliar market.
Distraction costs are driven by the loss of management attention to existing businesses. Each acquisition needs to be assessed for its distraction impact. How many managers will be involved in the acquisition and what would they otherwise have been doing? If the acquisition is likely to draw significant attention from existing businesses, it can easily lead to a loss of value in these businesses of 10–30 per cent.
Frequently, when managers do the maths for the full equation, a prize of 20 per cent quickly evaporates under the burden of 10 per cent learning costs, significant distraction costs and deal costs that often amount to more than 5 per cent.
Since the full equation often results in situations with big synergies looking as though they will only produce a small, rather risky, prize, it is often better to go for the synergies through a joint venture or an alliance. When the target is determined to sell, this lower risk solution may not be available. Nevertheless, it is important to assess whether the prize from a joint venture or alliance (no premium, reduced learning costs and lower deal costs) is likely to be greater. If so, it may be better not to bid for the target company and instead form an alliance with one of its competitors. As Denzil and Peter explain, acquisitions are usually a last resort.
Using these five rules is hard. They stop most deals. Hyperactive managers are usually uncomfortable, arguing that the rules are too pessimistic or that there are defensive reasons for deals that cannot be assessed through the ‘synergies less premium’ equation. However, the rules are based on simple logic and simple mathematics. Ignore them at your peril.
Andrew CampbellDirector, Ashridge StrategicManagement Centre