Evaluating acquisitions

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Evaluating acquisitions

The key to success in buying another company is knowing the maximum price one can pay and then having the discipline not to pay a paisa more

It is well-known that about 70-90 per cent of the Mergers and Acquisitions (M&A) fail to create value for shareholders. Yet, deals are getting bigger year after year. Worldwide, activity in M&As exceeded three trillion dollar for the fourth consecutive year in 2017 and is set to accelerate this year. Last year ended with the M&A world being witness to three major deals executed due to disruptions caused by companies like Amazon, Facebook and Netflix, who use their size and scale to push into new sectors.

Threatened by the prospective entry of Amazon into the pharmacy business, the largest chain of drugstores, CVS Healthcare, agreed to acquire healthcare insurer Aetna for approximately $69 billion. Australia’s Lowy family, who too were faced with the effect of Amazon on retail business worldwide, plans to sells Westfield, its global shopping centre business to France’s Unibail-Rodamco for $24.7 billion. Further, encroachment by Facebook and Netflix into sports rights, media and film production led Rupert Murdoch to sell much of his 21st Century Fox empire to Disney in a $66 billion deal.

In India, 2017 was an exciting year for M&As with a rise in both deal values and deal volumes. The year 2017 saw a 53.3 per cent rise in deal values to $77.6 billion as compared to the previous year at $50.6 billion. Deal volumes rose by 2.5 per cent to 614 deals in 2017; compared with 599 deals in 2016. Noteworthy amongst them were the acquisition of a stake in Bharti Airtel by Bharti Enterprises for $16.7 billion; the merger of Indian operation of Vodafone with Idea Cellular for $12.7 billion; the proposed acquisition of Hindustan Petroleum Corporation Limited  (HPCL) by Oil and Natural Gas Corporation (ONGC) for $8.5 billion; the acquisition of power business of Reliance Infrastructure by Adani Transmission and the merger of IndusInd Bank with Bharat Financial Inclusion for three billion dollar and $2.3 billion respectively.

Although deal values and volumes increase almost every year, most of them eventually fail to create a synergy. Among other reasons like nasty surprises due to poor due diligence, poor governance, poor communication channels, non integration of culture and weak leadership, paying a high price for acquisition is the main reason why M&As fail.

Microsoft’s acquisition of LinkedIn for $26.2 billion in 2016 was a mystery to a number of industry analysts as LinkedIn was plagued with problems of slow growth and had worst user engagement for a social media platform. It is likely that this deal too will end up going down the drain by taking a major write-down, just like the previous deals of Microsoft with Nokia and aQuantive.

Of course, Microsoft is far from being the only company to destroy shareholder value by overpaying to acquire other companies. Quaker Oats  acquisition of Snapple for $1.7 billion is a good example with some industry analysts estimating that the acquisition was overpriced by as much as one billion dollar. The stock price of both companies tumbled on the announcement of the deal and problems did not stop till Quaker Oats sold Snapple to Triarc Companies for less than 20 per cent of what it had paid.

Similarly, the present boom in the Indian stock market is having an inadvertent impact on M&As in the country by making them expensive. India Inc also has countless examples of overpriced purchases. Subex, once a fairy well-known Bengaluru-based telecom software maker, tipped into bankruptcy by the disastrous acquisition of Canadian telecom software company Syndesis for $164 million in 2007, which was four times its annual revenue. This deal turned out to be overpriced as Syndesis’ revenue in the following year halved.

Overpriced acquisitions are not a new phenomenon. But what makes a company ignore evidence and overpay for acquisitions? The answer lies mostly in behavioural theories. Agency problem is one of the main reasons for this, as in most of the cases, senior executives earn bonuses and stock grants based on metrics that have no real connect to value. Corporate governance and activist shareholders take a backseat as in practice, executives have higher influence on the process. So, they push the deals where they can make more money.

Second, when valuations are generally high, as in India, companies fall into overvaluation trap and end up making flashy acquisitions. Proposed by Michael Jensen of Harvard Business School, it is a behavioural trap where managers try to generate the expected performance in short-run, all the way knowing that maintaining higher performance is not possible; in-turn making investments that will ultimately fall short.

By making such investments, companies postpose the consequences of their bad investment decision. Too much money chasing relatively scarce investment opportunities is also one of the reasons why companies end up paying more for acquisitions. Ego, the driving force that help individuals reach the top of any organisation, is at play when it comes to acquisitions as well. It pushes executives to overpay for acquisitions so that they can get bigger and bigger; or so that they can stop a competitor from getting bigger than them.

Additionally, managers are also susceptible to Polyanna Principle, a psychological bias that overrates positive memories and discounts negative ones. This means that executives take cue from a few overpriced deals that were successful, like buying of PayPal by eBay for $1.5 billion or Google paying $1.6 billion for YouTube and turning a blind eye towards scores of overpriced deals that went kaput, such as the disastrous AOL/Time Warner merger that led to a $45 billion write-down.

Even experienced managers sometimes get attached to a deal, making them susceptible to bad decisions. In this situation, how should managers decide how much to pay or when to walk away? In this flashy corporate world, executives routinely get caught up in the excitement of the race; fall prey to it and offer more than they should. So the first criteria is to be disciplined and detached and the key to success in buying another company is knowing the maximum price one can pay and then have the discipline not to pay a penny more.

A company should be able to walk way from a deal if the synergy value is not being created. Even though a major competitor may be in the fray for it, one should not jump into buying the target company to outbid the competitor. If numbers do not add up, it is best left for the competitor to buy and weaken its competitive position. 

With experience, managers need to develop certain criteria for analysing any deal. For example, atleast the cost of capital of the company needs to be earned from the deal; earnings should not be diluted; the target company should have a higher growth rate; improvement in ROE among others.

With similar organisational discipline, companies can avert overpaying for acquisitions and stop destroying value for the acquiring company’s shareholders. Organisational discipline; analytical rigour and due diligence; victory over human emotions, ego and behavioural aspects and systematic corporate governance procedures can go a long way in making companies pay the correct value for an acquisition.

(The writer is Assistant Professor, Amity University)

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