CASE STUDY 4

Why Most Cross-Border Deals End in Tears

Simon London

Hardly a week goes by without news of a company abandoning plans for foreign expansion and retreating to its home market. The latest example of this sorry breed is Scottish Power, the UK utility, which is selling for $ 9.4bn (£5.1bn) the US business it acquired for $ 10bn in 1999. A $ 1.7bn write-off will result.

The tale is so familiar, it begs the question of why companies make overseas acquisitions at all. Yet they do – and in increasing numbers. Cross-border merger and acquisition activity increased fivefold in the 1990s and, following a brief lull, it is making a strong comeback.

Cross-border deals amounted to $ 75bn in the first quarter, a threefold increase from last year, according to Dealogic, the research firm. Eyecatchers include Pernod Ricard's proposed $ 13bn acquisition of drinks rival Allied Domecq and IBM's $ 1.75bn sale of its personal computer business to Lenovo, China's biggest personal computer maker.

Academic findings suggest three legitimate reasons for buying foreign companies. One: such deals can be a quicker, easier way to enter an overseas market than starting from scratch. The acquiring company buys not only an ongoing business but also a brand familiar to customers in the target country. If trade barriers are in place, an acquisition may be the only way to gain access to a new market.

Two: international diversification can stabilise cash flows and make the acquiring company appear less risky to financial markets. This may again, in theory, result in a lower cost of capital. Whether this happens in practice is a moot point.

Three: expanding into overseas markets increases the scale on which companies can exploit intangible assets (such as expertise and business processes) and technology. These are the “synergies” that executives tout as justification for almost every deal.

These potential benefits help explain why foreign bidders pay more, on average, for companies than their domestic counterparts. The propensity of overseas buyers to pay a premium, known in corporate finance circles as “the cross-border effect”, is well documented.

Jo Danbolt, lecturer in finance at Glasgow University, found that UK target company shareholders gain significantly more from cross-border than from domestic acquisitions. Foreign bidders offer better prices, and are also more likely to pay in cash.

So far, so good. There are sound reasons why companies might want to buy overseas and, in some cases, justifications for paying more than a domestic buyer. Yet research supports anecdotal evidence that most cross-border M&A ends in tears.

Sara Moeller, of the Cox School of Business at Southern Methodist University, and Frederik Schlingemann, of the University of Pittsburgh's Katz Graduate School of Business, studied 4,430 acquisitions by US companies from 1985 to 1995. They looked at both the initial stock market reaction to the deals and the longer-term operational performance of the acquirer. Their conclusion was unequivocal: “US acquirers experience significantly lower stock and operating performance for cross-border than for domestic transactions.”

Remember that the track record of domestic M&A deals is hardly stellar. Most academic studies have found that, on average, acquisitions destroy value. In those instances where value is created, it usually flows to shareholders of the company being acquired. Professors Moeller and Schlingemann found that cross-border deals underperformed even this dismal benchmark.

Ervin Black, of Brigham Young University, and Thomas Carnes and Tomas Jandik, of the University of Arkansas, reach a similar conclusion. In a study of the long-term share price performance of 361 successful US bidders for foreign targets, they say: “It appears that in the majority of instances, expansion of US bidding firms through acquisition of foreign targets is a value-destroying activity.”

So, while overseas acquisitions are justifiable on paper, in practice they usually fail. Bidders either find it difficult to value correctly the target company or they fail to capture synergies that were presumed to exist.

Differences in accounting standards can make it hard for the acquirer to understand the underlying performance of the target company. Even the best financial analyst will err if accurate balance sheet and cash flow data is not available.

“International accounting differences, whether they result in upward or downward biases in earnings, add noise to the reported earning number, making it more difficult to perform accurate financial analysis,” argue Professors Black, Carnes and Jandik. In domestic transactions, bidders respond to such uncertainty by offering equity. This gives shareholders and managers in the target company an incentive to make sure that all the facts are on the table. In cross-border transactions, however, investors are often reluctant to accept foreign shares in payment. The acquiring company has no alternative but to offer cash.

Even if potential synergies are valued correctly, the acquirer still has to capture them. This can be difficult in countries where the institutional structure and the framework of laws and regulations place restrictions on the actions of management. As a result, US companies moving into Europe find it easier to cut costs in the UK than in Germany, where extensive consultations are required by law before jobs can be eliminated.

Indeed, Professors Moeller and Schlingemann found that US bidders fared worse when target companies were located in countries with restrictive capital markets. The only exception to this rule was the UK, where returns to US acquirers were poor, notwithstanding a shareholder- and manager-friendly climate.

Even if the institutional structure is benign, however, managers have to deal with differences in business culture and custom. Only when they are comfortable working in the new environment – a process that could take years – will the acquiring company find it possible fully to capture synergies.

With such a weight of evidence against cross-border M&As, why do companies continue to shop overseas for off-the-peg opportunities?

Agency conflicts may be partly to blame. From this view, the hunger of senior executives (agents) for power leads them to make decisions that are not in the best interests of shareholders (principals).

Overseas acquisitions offering the glamour of jetset dealmaking may be more attractive to self-aggrandising managers than domestic deals.

The puzzle is that cross-border M&A continues to boom in spite of strenuous efforts to minimise agency conflicts by better aligning the financial incentives of managers with the long-term interests of shareholders. It is clear that more research is required.

In the meantime, long-suffering Scottish Power shareholders can take solace from knowing that their plight is hardly unique.

Why do a cross-border merger?

1. It can be a quick way to enter a foreign market.
2. International diversification can stabilise cash flows and make the acquiring company appear less risky to financial markets.
3. It widens the opportunities to exploit a company's intangible assets – such as expertise and business processes.

Why not do a cross-border deal? Acquirers experience lower stock performance when completing a cross-border deal than they do when closing a domestic deal. This is, principally, because of two factors: one, it is difficult to value a foreign target company accurately; and two, it is difficult to realise the synergies that are presumed to exist.

REFERENCES

Jo Danbolt, Cross-Border Acquisitions into the UK: An Analysis of Target Company Returns (2003)

Ervin Black, Thomas Carnes and Tomas Jandik, The Long-Term Success of CrossBorder Mergers and Acquisitions (2003)

Sara Moeller and Frederik Schlingemann, Are Cross-Border Acquisitions Different from Domestic Acquisitions? Evidence on Stock and Operating Performance for US Acquirers (2002)

All available for download from www.SSRN.com