Why Mergers Go Wrong

After a brief hiatus, mergers and acquisitions seem to be making a comeback. While research shows that most mergers and acquisitions fail to meet expectations, companies are once again trying to make them work. Have companies learned from their mistakes? We sat down recently to talk with three faculty members who teach about mergers and acquisitions —Mason Carpenter, John W. Eichenseher and James K. Seward — to get their input on what works and what doesn’t.

Determining a value for a company is crucial in merger and acquisition deals. Often value estimates differ dramatically. Why can’t we simply look at cash flows to determine a company’s value?

JOHN EICHENSEHER: Accrual accounting does not predict future cash flows with much precision. The basic notion is that the value is discounted future cash flows—but we have to estimate what those future cash flows are and we have to assess the associated risk. Discounted means there is some risk factor built it. If we get either of those factors wrong, we can be drastically wrong about the realization.

JAMES K. SEWARD: Valuation is difficult, not only in an M&A context, but in any context. To pay the right price for a target, you need to accurately estimate the target’s future performance. So, the acquirer needs to think about its future operating and financial strategies with the target, and to be realistic about the timing of changes in these policies.

I tell my students when they’re doing a valuation for a company, they need to think about motivation for a control transaction. One motivation is revenue expansion—this one seems to fail most often. If I buy a company thinking I’m going to be able to expand revenues going forward, there’s basically two things that matter—price and quantity—and managers don’t have direct control over either of these. Cost reduction strategies are a lot easier because more of these cash flows are under a manager’s direct control. But even in this case, coming up with the right discount rate for evaluating the cash flows is hard because I might be right on the amount of cost reduction, but I might be off on the timing because of integration problems.

One alternative valuation technique known as “comparable acquisitions analysis” that gets used too often is similar to deciding what to pay for a house. The idea is that I’ll just pay what the neighbor paid. Well, if that neighbor overpaid, I’m going to overpay for my house as well. The M&A market is the same way. When buyers get too aggressive, prices paid for targets increase to excessive levels.

MASON CARPENTER: Valuations are often off because of an overestimation of synergies. The idea is that a company will be able to grow reve-nue and reduce costs within the acquired unit and also across other divisions under the umbrella of the word “synergy.” Part of the reason synergies fall apart is because it’s very hard to bring compa-nies together. Culture is an important issue.

Is it possible to quantify the culture variable?

SEWARD: I’ve never seen anyone be successful at it. It’s a difficult thing to quantify, either cultural synergies or cultural negative synergies.

EICHENSEHER: Ultimately, everything comes down to cash flows. Ex-post we can value all this stuff. Beforehand, there are a lot of factors that simply cannot be quantified. That has to be rec-ognized in the decision-making process. You’re not going to get a metric, you’re not going to get a multiple, you’re not going to get a number. You’ve got to consider a whole range of factors.

What about after the merger? What are the primary considerations that determine successful integration?

CARPENTER: I would argue that integration starts before the deal is even done. There needs to be agreement on how things are going to go forward. There needs to be an alignment of in-terests. And then, there’s more than financial due diligence. There’s cultural due diligence. Organizations need to be willing to do this, to make some tough managerial decisions, to end up with one management team with one headquarters. Then, going forward to extract synergies, they need to move very quickly. Keep pushing until the organization is one unit. It can be in as little as 90 days for large organizations.

SEWARD: Once you get the knowledgeable people that are involved together, invariably you come to compromises. All of these little tweaky things come after the fact. Maybe it turns out IT systems aren’t compatible. Maybe employees don’t want to move to a new location. Figuring out how to integrate these things after the fact can mean the company spends a lot more to make the deal work. Careful due diligence prior to a transaction should adequately expose these issues. Unfortunately, careful due diligence is not always done.

So, it sounds like these discussions should take place before the actual deal is made.

SEWARD:Ideally, you’d like to be able to do that. A lot of things that as academics we might scoff at, happen. If the market is red-hot, companies may pull the trigger before they’re ready. The due diligence process today is much longer and more in depth than it was three years ago when the market was hot. CEOs are influenced by investment bankers who have their own agenda. They’re also influenced by other companies and what they are doing.

Comcast recently bid $54 billion to acquire Disney. Would this be a worthwhile acquisition? (Editor’s note: Pessimistic faculty comments on the proposed merger turned out to be prescient. Comcast decided to drop its offer to buy Disney in April, after negative reaction from its shareholders.)

SEWARD: It’s low-hanging fruit for Comcast, or any other qualified buyer. Here’s an example of Comcast admittedly behaving opportunistically. A 10 percent premium normally wouldn’t get anyone’s attention, but Disney has an inept Board of Directors unwilling to do what needs to be done to turn over the management. So, they’ve opened the door and basically put a big “For Sale” sign out. Comcast has no business being in the business Disney’s in. It ought to be interested in acquiring companies in the cable business. They know nothing about running theme parks.

What about Comcast’s argument that they want to be part of the content they’re distributing?

SEWARD:That argument has been used many times. I run as far as I can when I hear that argument. There’s no reason a company needs to be a full-integrated producer. That’s a bunch of baloney.

EICHENSEHER: That argument has no end, it’s like the auto industry arguing they need to be in the petroleum industry.

SEWARD: Companies should figure out what they do well and build competencies in that area. I’m willing to bet that if Comcast acquires Disney, they’ll dump a lot of stuff. They don’t need to have expertise if they’re able to find someone who does, who will pay a very high price. If they could acquire Disney at a 10 percent premium and then turn around and sell its parts at a 30 percent premium, they’ve done pretty well.

Doesn’t Comcast see itself as incompatible with Disney?

CARPENTER: They do not see themselves as incompatible culturally. They see it as different business but they say “we deal with content all the time, why can’t we build it?” Disney is a very creative business and Comcast just doesn’t have those skills. It goes back to doing what you do well, and in this case, what Comcast would be doing well is being an opportunistic buyer. I think the most positive potential outcome would be righting the governance that is incorrectly in place at Disney right now. But beyond that, I can see no value created.

When is big too big? Opponents argue this merger would reduce competition in the broadcast and entertainment industry and make it more difficult for smaller companies to compete. Can and should antitrust laws protect the balance in the market?

EICHENSEHER: With vertical integration, you can always tell a story about your opportunities being foreclosed because of some other company’s capacity. I’m more concerned with monopolization of a market than this vertical integration that is being argued in this case.

SEWARD: In the past, antitrust policy has been based on the protection of consumers. The EU recently has been more concerned with protecting competitors. As we have become more global, we see more inconsistencies. That can be dangerous.

EICHENSEHER: My presumption is that an organization like the WTO, which basically has a mandate only in trade at this point in time, eventually will talk about antitrust issues. I’m in favor of development of a global institution that deals with this, as opposed to a nationalistic approach, in order to protect consumers worldwide.

What should individual investors look for when a company they invest in is consider-ing a merger or acquisition?

SEWARD: I think you want to be on the sell side rather than the buy side of the transaction. There’s not much evidence that buyers have done particularly well. There is some evidence that buyers who use cash have done better than buyers who use stock. If I was on the buy side, I’d be more inclined to sit on the stock if I saw them using cash. Usually if they’re using stock, the stock is overvalued.

CARPENTER: I’d go back to the firm’s management and strategy. Does the firm have a history of making small incremental bets that are leveraged organically? There are companies out there that have done a good job of growing using acquisitions as a strategy, but not their only vehicle. It’s June 2004 9important for acquisitions to be part of a plan, rather than a substitute for a plan.

EICHENSEHER: If you really want to make returns in the market place, you have to dig in and look at individual situations. Everything’s conditional.

Mason Carpenter is an associate professor in the Department of Management and Human Resources. His research concerns corporate governance, top management teams and the strategic management of global firms. He has worked in banking, management consulting and software development. Carpenter has been published in several management journals and serves on the editorial board of the Academy of Management Journal.

John W. Eichenseher is chair of the Department of Accounting and Information Systems. His research interests are in the areas of auditing, cost data for decision making, financial reporting and service markets. His prior work experience includes serving as a faculty intern for Cargill Asia Pacific, Ltd. in Singapore and serving as an accounting education advisor to the Ministry of Finance in the Republic of Indonesia. He has been published in a variety of professional journals.

James K. Seward is an associate professor in the Department of Finance, Investment and Banking and Prochnow Fellow in Finance. He teaches corporate finance, financial management, corporate restructuring and mergers and acquisitions. His research interests include corporate restructurings, initial public offerings, use of equity-linked securities and the medium of exchange in corporate takeovers. His articles have appeared in leading academic journals. He is the executive director of the Nicholas Center for Applied Corporate Finance.

 

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