Corporate acquisitions often fail for one simple reason: the buyer pays too much. An old Wall Street adage comes to mind: Price is what you pay, value is what you get. It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the last trade. When a company is acquired, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.
Q4 hedge fund letters, conference, scoops etc
How much above? Acquisitions have the elements of a zero sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince both directors and shareholders that they are selling at a high (unfairly good) price. The buyer, meanwhile, must convince those same constituents that they are getting a bargain. Remember, both are talking about the same asset.
This is where a magic word — which must have been invented by Wall Street research labs — comes into play: synergy. The only way this acquisitions dance can work is if the buyer convinces his constituents that, by combining two companies, they’ll be able to create additional revenues otherwise not available to them, and/or they’ll be able to eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.
For example, General Electric has been a poor investment over the last two decades largely because of poor capital allocation. The company lost a lot of value in destroying acquisitions — they bought businesses at high prices, relied on false or unfulfilled synergies, and sold (divested) at reasonable (or low) prices.
Another reason mergers and acquisitions fail: “dis-synergies” (a term you’ll never see in an acquisition press release). Two corporate cultures simply may be incompatible. For instance, one company may have a strong founder-led culture, where decisions are made by a benevolent dictator, while in the other company, decisions are made by consensus. These two cultures will mix about as well as oil and water. Cultural incompatibilities only get worse when the buyer and seller are not engaged in the same business.
A prime example is Hewlett Packard (now HP) — the old grandfather of Silicon Valley — which has been substantially gutted by large acquisitions. When Compaq was acquired in 2002, HP’s unique engineering culture did not mix well with Compaq’s manufacturing culture. Then EDS (acquired in 2008) had a service culture, and Autonomy (in 2011) was a software company that actually ended up being a bag of bad goods (it used questionable accounting and overstated its sales). Each of these acquisitions severely damaged HP’s unique culture, and all were reversed through various spinoffs in recent years.
Acquisitions may also create a morale problem. The day before an acquisition is announced, people at the acquired company come to work as usual. They are not particularly worried about the future. The next day, though, their job security is suddenly at risk (remember, they are the potential “cost synergy”), and instead of hanging out on Facebook, they are now on LinkedIn updating their profiles and networking. They worry about the sustainability of their paychecks (and finding new jobs) a lot more than how they can help this great, new organization that in fact may be about to let them go.
Finally, integrating businesses is difficult. Aside from culture problems, companies have to realign global supply chains, move or combine headquarters, and integrate software systems. In large companies, this task is like merging two highly complex nervous systems.
Accordingly, while the acquisition press release may tout synergies, the price tags and dis-synergies (risks) that come with the deal are left unsaid.
Clearly, acquisitions can create value. But when a company grows through acquisitions, its management needs to have a specialized skillset that is often different from that used in running a company’s day-to-day operations.
It is important to examine the motivations of management when they make acquisitions. When management feels that their business, on its own, is threatened by future developments, their acquisitions will have a “Hail Mary” sort of desperation to them — and a corresponding price tag.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).
His books were translated into eight languages. Forbes Magazine called him "The new Benjamin Graham". To receive Vitaliy’s future articles by email or read his articles click here.
