Shareholder Value at Risk

In chapter 4 we made the case that the purchase price of an acquisition is typically driven by the pricing of other comparable acquisitions (“compaqs,” or precedent transactions)—often without a rigorous assessment of where, when, and how management can drive real performance gains. At the minimum, boards should be able to articulate how much shareholder value is immediately put at risk by their decision to approve a deal. Further, other choices that management recommends—particularly using cash versus stock to pay for the deal—impact the risks that boards should be able to understand.²

Before committing to a major deal, both parties will need to assess the effect on each company’s shareholder value should the synergy expectations embedded in the premium fail to materialize. In other words, boards must ask “What percentage of our company’s market value are we betting on the success or failure of the acquisition?”

A useful tool for acquirers assessing the relative magnitude of synergy risk is a straightforward calculation we call Shareholder Value at Risk (SVAR). SVAR is simply the dollar premium paid for the acquisition divided by the market value of the acquiring company’s shares before the announcement is made.

This index also can be calculated as the percentage premium multiplied by the market value of the target relative to the acquirer. We think of it as a “bet your company” index, or a measure of the materiality of a deal, which shows how much of your company’s shareholder value is at risk if no post-acquisition synergies are realized. The greater the percentage premium paid to sellers and the greater their market value relative to the acquiring company, the higher the SVAR. As we’ve discussed, it’s possible for acquirers to lose even more than their premium (if there is damage done to stand-alone growth value of either company). In these cases, SVAR underestimates risk.

The use of cash versus stock as the method of payment has profound ramifications for the shareholders of both acquiring and target companies, and a substantial impact on SVAR. In a cash deal, the roles of the two parties are clear-cut, and the exchange of money for shares completes a simple transfer of ownership. But an exchange of shares presents a far less clear picture of who is the buyer and who is the seller. In some cases, the shareholders of the target company can end up owning most of the acquirer that bought their shares.³

Companies that pay for their acquisitions with stock share both the value and the risks of the transaction with the shareholders of the company they acquire. The decision to use stock instead of cash can also affect shareholder returns. Past research on M&A has consistently found that, at the time of announcement and beyond, shareholders of acquiring companies fare worse in stock transactions than they do in cash transactions. What’s more, the findings from our M&A study confirm this and show that early performance differences between cash and stock transactions get greater—much greater—over time.⁴

Despite their obvious importance, these issues are often given short shrift. Boards, executives, and journalists tend to focus mostly on the prices paid for acquisitions. It’s not that it’s wrong to focus on price; price is certainly an important issue confronting both sets of shareholders. But when companies are considering making—or accepting—an offer for an exchange of shares, the valuation of the company in play becomes just one of several factors that managers and investors need to consider. Let’s look at the basic differences between stock and cash deals.

How Can Companies Choose?

Given the dramatic effects on value that the method of payment can have, boards of both companies have a fiduciary responsibility to incorporate those effects into their decision-making processes. Acquirers must be able to explain to their shareholders why they will have to share the synergy gains of the transaction with the shareholders of the target. For their part, the target’s shareholders, who are being offered stock in the combined company, must be made to understand the risks of what is, in reality, a new investment. All this makes the board members’ job more complex.

The PMI Board Pack

As we discussed at length in chapters 6, 7, and 8, post-merger integration (PMI) is a highly complex process. The pace, importance, and sheer number of decisions that will need to be made for a merger far outstrip the normal rate of decision-making. Combining two organizations with distinct cultures while trying to manage business as usual and protect the day-to-day cash flow is daunting. In most organizations, PMI is not a core skill.⁶

Directors must feel confident that the claims of management are supported by at least the foundations of an integration plan before approving a deal—and senior executives, knowing this, should be prepared by all of the work they have done to assess the deal. Ultimately, investors will want to feel confident that management has a plan.

Boards are regularly presented with a review of the strategy and valuation of the deal, often supported by a fairness opinion, but there is usually little about how the companies will be integrated. The PMI Board Pack is designed to help the board ensure that senior management is ready to avoid the common pitfalls of PMI. As a summary for board members, there are four major reasons that PMI efforts fail to deliver what has been promised:

1. Loss of focus:  There is little structure to the PMI so executives and employees are distracted from running the businesses and worrying about customers and competitors. Employees spend a lot of time looking for other opportunities.
2. Wasted time:  The organization does not appear able to begin generating synergies at closing so the present value of any synergies eventually obtained is greatly reduced. As delays continue, employees lose confidence in the deal’s strategic rationale and competitors have time to respond. Management fails to prioritize and make tough decisions, either not addressing the big, tough decisions early, or getting mired in slow decision-making processes.
3. Competitor reactions and changing business environment:  The PMI is carefully planned but lacks a structure that will allow the organization to quickly revisit and modify plans as needed. In short, the PMI becomes so internally focused that the organization is not prepared to respond to changing business conditions.
4. Failure to follow through on plans:  The PMI focuses on designing the new organization and delivering early synergies but not on resolving the thousands of bottom-up issues to transition the organization through the end state vision. The result is a failure to deliver the new organization needed to support the businesses and achieve the synergy targets.

During its review of the deal, the board is in a unique position to ensure not only that a proposed transaction makes sense strategically and financially but also that the groundwork has been laid to deliver the promised results. Without such plans, deal value may begin to leak. By making specific demands of senior management, directors can have a tremendous influence on the outcome. Before a deal is approved by the board and announced publicly, senior management should present the following five essential elements:

1. A PMI process calendar showing phasing of activities and decisions
2. The key top-level shaping decisions to be made up front
3. A tailored integration approach that is clearly articulated
4. The structure, teams, and resourcing to deliver the PMI
5. The business plan that delivers the performance promises for the deal

The Meet the Premium Line and Plausibility Box

While much has been written about the shortcomings of relying on earnings accretion and market multiples to reach acquisition decisions, short-term earnings accretion to the acquirer remains one of the most popular thresholds in judging whether or not to do a deal. It’s also typically the first order of business in investor presentations. So rather than present one more argument against the popular use of earnings in evaluating M&A transactions, we show here how to use earnings-based financial information in a way that would be much more useful to senior executives and boards before they agree to pay a significant premium for another company.⁸

For any transaction with a significant SVAR (with significance to be set by the board), we present a simple “earnings” model for the target that yields combinations of cost reductions and revenue enhancements that would justify a given premium. This way, any talk of a deal being accretive to earnings—along with the logic of the deal—can then be readily scrutinized in operating terms that are familiar to most corporate managers and investors. While this is no substitute for a properly executed DCF valuation, it is another way of enabling boards to avoid obvious mistakes—especially when deals appear to be “accretive.” Our approach also yields some simple metrics that allow a sanity check of the PMI business plan.⁹

The equity market value of a public target (MV_T) prior to the acquisition announcement can be expressed as a multiple (P/E_T) of its after-tax earnings (E_T) as follows:

(1) MVT = ET × P/ET

When an acquirer offers a premium (%P) for the target company, the dollar value of the premium offered is simply the product of the premium (%P) and the pre-announcement target equity market value (MV_T).

That offer premium can also be stated in terms of the after-tax earnings of the target (E_T) and its price-earnings multiple (P/E_T):

(2a) %P × MVT = %P × (ET × P/ET) = (%P × ET) × P/ET

Equation (2a) implies that, in order to earn the dollar premium offered for the target, the target’s after-tax earnings (E_T) must increase by %P and then be maintained in perpetuity. But this assumes that the earnings multiple (P/E_T) of the target remains unchanged.¹⁰ Assigning the same P/E also assumes that any earnings improvement from synergies will be assigned the same P/E as the pre-deal P/E.¹¹

To illustrate: If an acquirer offers a 20 percent premium over the target’s pre-announcement market value (and provided we assume a constant P/E), the target must generate a 20 percent increase in after-tax earnings. Substituting pre-tax profit margin (Π), revenue (R), and the effective tax rate (T) for E_T, we have an expression of the incremental after-tax earnings required:

(2b) %P × ET = %P × (R × ) × (1 − T)

Because this increase in after-tax earnings must be delivered through the generation of pre-tax synergies, these pre-tax synergies—%P × (R × )—are our focus.

Some acquirers focus exclusively on cost reduction or revenue improvement, but the more common approach is to seek a combination of the two.

In the case where an acquirer intends to earn the acquisition premium entirely through cost reductions, we define %SynC as equal to the pre-tax earnings improvement required as a percentage of the pre-acquisition addressable operating cost base of the target. We find %SynC to be a useful measure of how challenging it will be for an acquirer to justify the acquisition premium from an operational perspective. By putting the cost reduction in percentage terms, a CEO or business leader would need to defend the feasibility of the reduction.

Alternatively, using both pre-tax operating profit margin (Π) and revenues (R) to reflect the operating cost base in the denominator, we arrive at the following expression:

Equation (3b) shows that, by considering just the percentage takeover premium and the pre-tax operating profit margin (which we set as EBIT), the proposed pre-tax earnings improvement from a deal can be quickly evaluated from percentage cost reductions alone. So, for example, a proposed deal at a 35 percent premium on a target with an 18 percent pre-tax margin will require a 7.7 percent [0.35 × (0.18/(1 − 0.18))] decrease in operating costs to achieve enough pre-tax profit improvement to justify the premium and just break even. And remember, for those cost reductions to represent synergistic gains from the merger, the cost savings would have to come on top of any reductions already expected in the stand-alone plans of the two companies.

Although this may be intuitively obvious, the model suggests a more aggressive %SynC for higher-margin businesses for a given acquisition premium. This reflects the simple fact that a higher-margin business has a smaller percentage cost base. An aggressive %SynC in such a business requires going deeper to make a difference to the bottom line, and going deeper may mean cutting away fat and muscle—which makes meeting the premium through cost reduction more challenging.¹²

In cases with potential revenue as well as cost synergies, a simple adjustment to equation (3b) can be made to estimate the cost reductions that would be required after taking account of the benefits of the expected percentage increase in revenue, or revenue synergies (%SynR). In other words, the more synergy from revenue gains, the less the burden on cost reduction.

Using equation (4b), we can compute the cost synergies required to earn the offer premium for any deal, given three variables: the premium offered, the pre-tax operating margin (EBIT), and the expected percentage revenue synergies.¹³ If %SynR equals the premium percentage, then no cost synergies would be required in this model for a given acquisition premium.

The equation yields what we call the Meet the Premium (MTP) Line. Figure 9-1 shows the MTP Line that depicts those combinations of %SynC and %SynR that generate enough pre-tax synergies to equal—but not exceed—the hurdle posed by a 35 percent premium and a pre-tax operating profit margin of 18 percent. If the expected percentage revenue increases equal the premium percentage (35% in this example), then no cost reductions would be required to justify the premium. And, as we have already shown, in the absence of any expected revenue increases, the cost reductions necessary to meet the premium are 7.7 percent. (Those endpoints effectively represent the %SynC or %SynR required to meet the premium in the absence of the other.)

FIGURE 9-1

The MTP Line

The importance of the MTP Line for senior management teams and boards is straightforward: Deals whose benefits put them below the line should be avoided—or at least put under more scrutiny. Points A and B are deals an acquirer should seek to avoid, whereas the expectations for the deal represented by point C would more than justify the premium using this approach. And the higher the premium paid for the target, the larger the combination of %SynC and %SynR necessary to earn the premium. (In terms of figure 9-1, any proposed increase in the premium above 35% would call for a parallel upward shift in the MTP Line.)

This simple picture can be used to inform and guide detailed discussions about the combination of revenue and cost synergies that management believes it can achieve in a potential deal—which should become the focus of management’s communication to investors. The upshot: If you can’t plot a point, what will you tell investors?

Besides testing the competitive assumptions that would drive projected revenue synergies, several other questions need to be answered. For example, what is the addressable cost base—that is, how much of the cost base can actually be reduced (does it include overheads, indirect expenses, etc.)? Deals with a seemingly high cost base may in fact have few components that can be managed, unless the acquirer has specific capabilities to do so. It also begs the big question of what the experience has been for the acquirer, and other acquirers in the industry, in realizing synergies in similar deals.

In our experience, companies are generally more successful in reducing costs than in increasing revenue. It is easier to take out costs by, say, closing facilities and reducing headcount; these are internal issues that are controllable, visible, and tangible. Cost considerations also generally come first. They tend to be approached by fresh troops with all their energy focused on getting something done and achieving quick cost-reduction wins.

Revenues, on the other hand, are affected by competitor and customer reactions. For this reason, they are harder to anticipate and control, particularly in cases where the benefits are expected to come from cross-selling initiatives. Moreover, the analysis and commitments required for growing the revenue line are often deferred until after the businesses are stabilized and the cost issues are under control. (See chapter 8 for a more detailed discussion on revenue growth.)

That delay, however, often has unwanted consequences. Competitors are given time to react in the marketplace by protecting their customers and approaching those of the new combined firm. They will anticipate the acquirer’s moves and court the best customers of the acquirer and target by playing up the disarray of the new firm and the lack of customer service that is likely to follow. Delaying the focus on revenue synergies also allows plenty of time for headhunters and competitors to poach the best salespeople. And it also often means that the organization is fatigued from the demands of PMI by the time it worries about its new go-to-market strategy and how it will serve customers in ways it couldn’t before. Moreover, when cost reductions take priority over revenue growth—or are just viewed independently of it—the infrastructure required to support potential revenue growth can end up being cut.

When evaluating projected synergies, setting reasonable thresholds above which successful cost reduction and revenue improvement become implausible is critical in assessing the extent of the operating challenges associated with any deal being contemplated. In figure 9-2, we show how these thresholds form a “Plausibility Box” that can be used to assess whether the envisioned combination of required synergies for a given target is reasonable, even when that point lies on or above the MTP Line.

FIGURE 9-2

The Plausibility Box

Figure 9-2 illustrates a hypothetical box with an upper range of 10 percent operating cost reduction and 10 percent revenue synergies.¹⁴ (Only point C is both plausible and sufficient to meet the premium.) In practice, an acquirer can set the parameters of this box any way it wishes provided it has the supporting evidence. The evidence can be drawn from an acquirer’s experience or industry synergy benchmarks. This is also a useful sanity check tool for assessing a sensible price range, given various combinations cost and revenue synergies.

Our assumption is that synergies will begin immediately, so any expected differences in the timing of revenue versus cost synergies must be made explicit and addressed. Any projected delay in realizing the synergies required to justify any significant premium will cause investors to mark down the price of the acquirer’s shares to reflect those delays right at announcement. As our M&A study clearly shows, that price reduction puts the acquirer into a hole and sets a negative tone that can affect organizational morale, especially those employees whose pension assets are invested in the acquirer’s stock.

In summary, boards must consider these two questions when evaluating a proposed deal:

1. Does the proposed combination of percentage cost reductions and percentage revenue increases, the synergies, fall above the MTP Line?
2. Does that point also fall inside a range that is plausible?

The Capabilities/Market Access Matrix and the Synergy Mix

Having set the stage for those two questions, the next step in the analysis is to consider whether the proposed combination of cost and revenue synergies—even if that point falls within the Plausibility Box—makes operating sense, given the strategic intent of the deal and the assets the transaction brings together. In this section, we present a framework for having that discussion. Then we use four major deals to illustrate how it might be applied.

There is a vast literature on the effects of diversification and relatedness on the value added by M&A.¹⁵ The objective of that literature has been to classify deals into a single category—typically “related,” “unrelated,” or some intermediate category—and then compare the average performance of the categories to judge which is better or worse. This literature also reflects a long history of academic debate, with a stream of conflicting findings.¹⁶ But while the debate has provided grist for the academic mill, it has given practitioners little help in assessing specific deals. And, unfortunately, the practitioner literature on the subject has also resorted to such “categorizing.” In this body of work, deals are typically referred to as “core,” occupying an “adjacent” space, or constituting a “diversifying” move.¹⁷

The problem with putting deals into such categories is the failure to consider the very real possibility that any given deal will span a range of categories, depending on the capabilities and market access that are brought together in the combination.

Figure 9-3a presents a three-by-three matrix that we have found far more helpful in both operating and board-level discussions than assigning deals to a single category based on a vague idea of relatedness. Using our framework, deals can fall into different combinations of categories, depending on the strategy for creating value and the assets that are being combined.¹⁸

With the help of figure 9-3a, any deal can be characterized in terms of 1) the parts of both businesses that offer the same capabilities (e.g., R&D, product design, product portfolio, operations, cost structure, supply chain, systems) and market access (e.g., channels such as sales force and third-party relationships, geographic presence, brand, channel power); 2) the parts of the businesses where one company has a clear advantage over the other and is simply better; and 3) the parts of the businesses that bring together new, or non-overlapping, capabilities or market access.

The shaded zones in the Synergy Mix chart in figure 9-3b illustrate how different spaces in the Capabilities/Market Access Matrix translate into different types of potential synergies, and thus map to a range of different cost and revenue synergy combinations on the %SynR/%SynC graph (on which we showed the MTP Line in figure 9-1). The result will form the basis for the mix of synergy expectations that management will hold up for investors.

FIGURES 9-3A AND 9-3B

Capabilities/Market Access Matrix and Synergy Mix

Different spaces in the capabilities/market access matrix suggest the potential to yield mainly cost or mainly revenue synergies, or a combination of both. Deals that bring together the same capabilities and market access will yield mainly cost benefits (“efficiency”) because of the potential for scale and redundancies. Deals that have overlap but bring better capabilities or market access can yield both revenue synergies and cost synergies (“enhancement”). And deals that bring together new capabilities or market access, with little overlap, will be expected to add value mainly through increases in revenue (referred to as “expansions” in cases where there is some overlap and as “expeditions” where there is none). Most significant deals will involve some combination of the nine spaces in the matrix. Now is the time to have these discussions.

A Model of How to Do It

A good example of a transaction that gave investors trackable and defendable synergy forecasts, and thus signaled the acquirer truly had a plan, was PepsiCo’s $13.4B all-stock acquisition of Quaker Oats announced in December 2000.²⁰ (We discussed PepsiCo’s investor presentation for the deal in chapter 5.)

PepsiCo’s management described in detail where it expected synergies, distinguishing highly probable gains from those it anticipated but did not include in the investor model. Recall that they identified a total of $230M of synergies, which they expressed in terms of the following contributions to operating profit: $45M from increased Tropicana revenues (same capability with better market access); $34M from Quaker snack revenues sold through the Frito-Lay system (same capability with better market access); $60M from procurement savings (same/same); $65M from cost savings derived from SG&A expenses, logistics, and hot fill manufacturing (same/same); and $26M saved by eliminating corporate redundancies (same/same).

Thus, the deal had a center of gravity relatively close to the core businesses (and the lower-left spaces of figure 9-3a), and it was clear what investors—and employees—could expect in the parts of the business from where synergies were to come. They could easily see how the deal would produce improvements in operating profit and more efficient use of capital that would more than justify the modest 22 percent acquisition premium.

The management team also articulated clearly how they planned to integrate Quaker Oats and several of its brands into PepsiCo and how capabilities from both companies would be leveraged to achieve additional growth. Moreover, Roger Enrico, PepsiCo’s outgoing chairman, stressed that management used conservative estimates for cost savings and revenue synergies.

PepsiCo’s announcement was received positively by investors. Its shares rose by over 6 percent (nearly $4B) in the days following the announcement and continued to outperform the shares of its industry peers throughout the decade after the transaction closed in August 2001.

Like PepsiCo, Nexstar Media’s $6.4B (with assumed debt) all-cash acquisition of Tribune Media, at a 20 percent premium, offered a compelling investor presentation with trackable synergies of $20M in corporate overhead savings, $65M of expense reduction from stations, and $75M of revenue synergies from net retransmission revenue applying Nexstar rates to Tribune’s subscriber counts—or $160M of synergies all realized in the first year after close. (We also addressed the Nexstar acquisition in chapter 5.) Nexstar CEO, Perry Sook, emphasized the company’s disciplined management team with a strong track record of M&A integration and delivering synergies (at close Nexstar increased its synergy projection to $185M).

Placing these synergy projections into figure 9-3a shows that the deal had a center of gravity close to the bottom left with $85M (same/same) from efficiencies and $75M (same capability/better market access) from revenue. That yielded a Synergy Mix consistent with the assets coming together and investors could easily plot the point of revenue and cost synergies that was above the MTP Line for an 11 percent increase (nearly $400M) in Nexstar’s shares at anouncement.²¹

And Some Contrast

A different picture is provided by AOL’s acquisition of Time Warner announced in January 2000, and Hercules’s acquisition of BetzDearborn announced in July 1998. The AOL/Time Warner deal involved a $51B premium (56%) and brought together radically different businesses, and yet the investor presentation projected $1B in cost synergies—without any guidance as to where those synergies would come from. That deal was what we would classify as an “expedition,” and thus there was no plausible basis for projecting that level of cost synergies.

The Hercules/BetzDearborn all-cash transaction involved a whopping 95 percent premium (nearly $1B) and brought together businesses that appeared to have some overlap in paper process chemicals, where $100M of cost synergies was projected in the investor presentation. But a closer look shows that Hercules competed in functional paper chemicals that improved the properties of paper while BetzDearborn sold paper process chemicals that improved the performance of paper machinery. In addition, more than half of BetzDearborn’s $1.3B of revenues came from a large water treatment business in which Hercules had no presence.

While both Hercules and BetzDearborn had significant channel overlap with paper customers, the deal would have mapped mainly into the expansion and expedition spaces on the right side of our matrix in figure 9-3a. Thus, according to the Synergy Mix diagram in figure 9-3b, we would have expected to see management projections mainly of revenue synergies from cross-selling initiatives but only a modest amount of cost reduction (e.g., corporate overhead).

Figure 9-4 illustrates the case for each of the four deals.²² The lines on the graph represent the MTP Lines as noted for each deal, and the dots represent the corresponding combination of revenue and cost synergies that were presented in the respective investor presentations.²³ While all four of those points fall within our hypothetical plausibility box from figure 9-2, only the proposed Synergy Mixes for the PepsiCo/Quaker and Nexstar/Tribune deals lie above the MTP Line. More important, the points for both PepsiCo/Quaker and Nexstar/Tribune indicate a combination of projected cost and revenue synergies that is consistent with the deal strategy and the assets that were brought together.

FIGURE 9-4

Announced %SynR / %SynC points relative to MTP Lines

Note: Quaker dot is plotted at (10.0%, 3.6%); Time Warner dot is plotted at (0.0%, 4.2%); BetzDearborn dot is plotted at (0.0%, 9.2%); Tribune dot is plotted at (3.7%, 5.1%).

The $1B of pre-tax cost synergies announced for AOL/Time Warner put the deal well below the MTP Line in figure 9-4. Moreover, the resulting projected %SynC of roughly 5 percent is difficult to substantiate given the expeditionary nature of the deal (i.e., “new/new” in figure 9-3a). Not surprisingly, the initial market reaction to the announcement of the AOL/Time Warner deal was significantly negative—a 15 percent decline (or more than $30B)—and the synergies had been discounted to almost zero by the time the deal closed.²⁴

Similarly, the $100M of pre-tax cost synergies projected for the Hercules/BetzDearborn deal put that transaction far below the MTP Line and without a sensible Synergy Mix. The announcement of the deal was met with a nearly 14 percent reduction (or $485M, almost half the premium) in the price of Hercules shares and the company’s shares continued to fall from there.

Conclusion: The Duty of Care Imperative

Major acquisitions are only one of many governance issues on the plate of today’s boards—but it is a big one. Directors now understand they will be held accountable by shareholders, especially for “bet the company” decisions. Poorly planned and executed acquisitions have almost certainly destroyed far more investor value than managerial acts of fraud. (See the sidebar, “Questions from the Board.”)

Although the methodology we’ve presented here is by no means a substitute for thorough due diligence of the deal thesis, a proper DCF analysis of a proposed deal value (see chapter 4 for our analysis of DCF valuations), and early PMI planning, it is a useful complement, and we hope it can be used to provide CEOs and boards with relatively simple but reliable guidance and the basis for active discussions with senior leadership. Where the results of our methods are at odds with the DCF analysis (or EVA assessment) and the logic of the inputs, then the assumptions of the DCF analysis should be investigated.

The key issue that boards must address is: How will this deal affect our stock price and why? The time to stress test the deal strategy, proposed benefits, valuation, integration preparation, and communications plans of the senior team is not after the deal is announced. Implementing our approach may seem challenging, but it translates to some minimum basic considerations for directors. Before approving a deal and recommending it to shareholders, directors should ensure that senior management offers a clear business case and has an operating model—and a plan—in place. And, knowing this, senior executives must be prepared to withstand such scrutiny.