World
Global Strategy
Mind Matters
Failure is an option: an investor’s guide to M&A
James Montier
(44) 20 7762 5872
james.montier@sgcib.com
IMPORTANT: PLEASE READ
DISCLOSURES AND DISCLAIMERS
BEGINNING ON PAGE 12
www.sgresearch.socgen.com
19 November 2008
Perhaps the most egregious evidence of corporate management delusion can be found in the
realm of M&A. A quite outstanding 93% of managers think the M&A they do adds value, but
objective measures show only around 30% of deals actually add value. So scepticism should
be the default option for investors when it comes to M&A deals. However, several factors limit
the degree of value destruction investors may face. The ‘perfect’ deal from an investor’s
perspective is a cheap private firm with good governance as a target, with an acquirer
motivated by increasing focus and cost-cutting synergies, financed by cash at a time of low
M&A activity.
Q The mismatch between corporate managers’ view of their M&A success and the
objective measure is truly mind-blowing. Some 93% of managers think their M&A adds
value, whereas the data shows that less than one in three deals actually do. Either corporate
managers simply don’t conduct post-deal analysis, or they ignore the results. Witness the
delusional statement of DaimlerChrysler’s CEO concerning the disastrous deal, that the
merger was “an absolutely perfect strategy”.
Q The two most common rationales for M&A deals are to ‘take advantage of synergies’ and
to ‘diversify’. Unfortunately both of these motives can be a source of major problems for
corporates. A survey by KPMG found that only 30% of firms conducted a robust analysis of
the expected synergies! Investors should then be especially wary of deals based on
‘revenue synergies’, as apparently nearly 70% of mergers fail to achieve the expected level
of revenue synergies.
Q The dream deal from an investor’s perspective is a cheap firm with good governance as a
target, with an acquirer motivated by increasing focus and cost-cutting synergies. The
managers of the firm would be paid based on operational performance. The deal would be
cash financed and occur at a time of generally cheap markets and low M&A activity levels.
Q In contrast the deal from hell would involve an expensive public firm with poor
governance as the target. The acquirer would be motivated by empire building
diversification, effectively addicted to repeated M&A. The rationale would be based on a
‘pipedream’ of revenue synergies. Such a deal would be financed purely via stock, and the
managers would receive a completion bonus. This deal would also occur when the market
was generally expensive and the M&A was the flavour of the month.
 Mind Matters

Failure is an option: M&A from the investor’s

perspective

Delusions of management
According to the latest biannual KPMG survey of global M&A 1, a truly staggering 93% of
corporate managers think that their M&A adds value. This must surely be the most damning
evidence of the over-optimism and over-confidence on the part of corporate managers that I
have ever come across.

The chart below shows the contrast between an objective measure of M&A performance – it
contrasts the percentage of firms who conducted M&A deals that managed to outperform
industry peers in the stock market during the two years following the deal against managers’
subjective belief regarding the percentage of deals that added value.

Strangely enough, the managers’ beliefs are always massively above the objective measures.
For instance, in the latest survey KPMG show that while 93% of managers think their M&A
work added value, fewer than 30% of deals actually did so.

Objective or subjective: % of M&A that is successful

100
90
80
70
60
50
40
30
20
10
0
1999 2001 2003 2006 2008
% of M&A that add value (objective) % of managers who think their M&A added value

Source: KPMG, SG Equity Research

This chart also provides evidence of another behavioural trait that I often refer to which is our
very limited ability to learn from mistakes. You might have been forgiven for thinking that over
the course of the last decade or so, managers might perhaps have come to realise that M&A
should be treated with extreme caution. However, nothing could be further from the truth. In
fact, corporate delusions with regard to the value of M&A only seem to have increased!

This shows that corporate managers simply just don’t conduct any thorough post deal
performance analysis, or that if they do, they simply ignore the outcome! A prototypical
example of this failure to objectively measure the post deal performance is provided by
DaimlerChrysler. The merger failed on any operational definition. It destroyed value roughly

1
15th October 2008

2 19 November 2008
 Mind Matters

equal to the total purchase price of Chrysler. Yet even after acknowledging these appalling
consequences, the CEO Jurgen Schrempp continued to defend the merger as “an absolutely
perfect strategy”.

2
Similar evidence of such delusional thinking was found by Bruner . He surveyed 50 business
executives and found that they thought that only 37% of deals created value for the buyers,
but that 58% believed their own deals created value. Similarly, they thought that only 21% of
all deals achieved their strategic goals, but that 51% of their own deals did in fact deliver on
their strategic goals.

Others’ M&A vs own M&A

70
In general
60
Own

50

40

30

20

10

0
Added Value Achieved strategic goals

Source: Bruner (2004) SG Equity Research

The bad news for managers and investors alike is that study after study finds that the
acquiring firms tend to underperform the market in the long-run. For instance, a new study by
Ben-David and Roulstone 3 shows that the acquiring firms underperform by -13% in their first
year (after adjusting for the market, size and style) and -25% over the three years post deal.

Performance of M&A (abnormal returns, %)

Over one year Over three years

0

-5

-10

-15

-20

-25

-30

Source: Ben_David and Roulstone, , SG Equity Research

2
Bruner (2004) Applied Mergers and Acquisitions
3
Ben-David and Roulstone (2008) Why do small stock acquirers underperform in the long-term?

19 November 2008 3
 Mind Matters

Rationales for value destruction

So what rationale do managers use to justify their value destructive behaviour? An intriguing
survey by Mukherjee et al 4 actually performed a survey of managers of US firms who had
conducted M&A between 1990-2001 5. The reason most commonly cited was to “take
advantage of a synergy”, followed by “diversify”. Bizarrely, from my value-orientated
perspective, only 8% of corporate managers said they conducted M&A because the target
was cheap.

Rationales for M&A (Percentage of participants citing reason)

0 5 10 15 20 25 30 35 40

Take advantage of syngery

Diversify

Restructuring

Cheap target

Use free cash flow

Reduce tax

Other

Source: Mukherjee et al, SG Equity Research

Value matters
This indifference towards the value of the firm also flies in the face of the academic work in
this field. Using the harshest possible tests, Mitchell and Stafford 6 show that the three-year
7
post-merger abnormal returns for acquiring firms differ markedly depending upon whether
the target was a value stock or a growth stock. Firms that acquired growth stocks delivered
on average a -7.2% abnormal return (value weighted, 1961-1998), while firms that purchased
value stocks delivered a 1.1% abnormal return.

8
This work was recently updated by Song . He shows the impact of the tech bubble on these
numbers. If an acquirer bought a growth stock in the period 1997-2003, then the abnormal
returns drop to -21%, whereas acquirers of value firms delivered an abnormal return of 3.8%.
Ignore valuation at your peril.

4
Mukherjee, Kiymaz and Baker (2004) Merger motives and target valuation
5
Mukherjee et al also find that DCF is the way most firms value their acquisitions; given my recent note on
the problems inherent in the DCF approach this is yet another nail in the coffin for M&A see Mind Matters,
9 September 2008).
6
Mitchell and Stafford (2001) New evidence and perspectives on mergers
7
Abnormal returns are adjusted for market and size
8
Song (2007) Does overvaluation lead to bad mergers?

4 19 November 2008
 Mind Matters

Value matters for M&A

10
Growth firms
5 Value firms

-5

-10

-15

-20

-25
1961-1998 1997-2003

Source: SG Equity Research

Beware synergies (especially revenue based)

In contrast to the relative simplicity of the issue regarding the value of the target, the two most
commonly cited reasons for doing M&A deals mentioned above are fraught with difficulty. The
reliance on synergies in managers’ thinking helps explain why it is that so many mergers and
acquisitions fail. It is very easy to over-estimate the available degree of synergies that are
achievable, and if managers are over-confident and over-optimistic, this is only to be
expected.

Yet the evidence shows that synergies can be exceptionally difficult to realize. The 2006
KPMG survey shows that of the 30% of firms whose M&A added value, 61% met or exceeded
their synergy targets. In contrast, for the 70% of deals that failed to add value, only 35%
managed to achieve their expected synergies.

Yet despite this uncertainty over the achievement of synergies, some 43% of the expected
synergy value was included in the purchase price. Perhaps even more astounding, the KPMG
survey showed that only around 30% of firms had conducted a robust analysis of the
expected synergies before the fact!

Christofferson et al 9 investigate which sort of synergies seem to be easier to deliver from the
managers’ perspective. Expected revenue synergies appear to be where managers are most
likely to overestimate the available returns. Christofferson et al uncover that nearly 70% of
mergers failed to achieve the expected revenue synergies. Indeed, nearly one-quarter of
mergers failed to achieve even 25% of the expected revenue synergies.

9
Christofferson, McNish and Sias (2004) Where mergers go wrong, McKinsey on Finance (Winter 2004)

19 November 2008 5
 Mind Matters

% of expected revenues synergies achieved

25

20

15

10

0
<30% 30-50% 51-60% 61-70% 71-80% 81-90% 91-100% >100%

Source: SG Equity Research

In contrast, managers seem to be much more able to deliver cost-cutting synergies – only 8%
of mergers failed to deliver less than 50% of the expected cost-cutting synergies. Over 60%
of mergers managed to deliver at least 90% of the expected cost-cutting synergies. However
a quarter of mergers still managed to overestimate the scale of cost-cutting benefits by 25%.

% of expected cost synergies achieved

40

35

30

25

20

15

10

0
<30% 30-50% 51-60% 61-70% 71-80% 81-90% 91-100% >100%

Source: SG Equity Research

These chart show that managers over-estimate the likely scale of synergies (consistent with
the explanations and arguments of behavioural psychology). They also suggest that M&A
based on revenue synergies should be treated with enormous skepticism. M&A based on cost-
cutting appears easier to achieve (although managers are still prone to over-estimate the scale
of the available benefits).

The dangers of diversification

The second key driver that Mukhejee et al uncovered was diversification. Sadly, again we run
into problems that suggest that this is all too often a misguided motive. The consulting firm
Bain and Co have shown that 75% of moves into so-called adjacent markets end in failure.

6 19 November 2008
 Mind Matters

The finance literature offers a cautionary tale for would-be diversifiers. A paper by Megginson
et al 10 explores the performance of focus decreasing and focus increasing mergers. The
results make unpleasant reading for those who argue that diversification is a good thing.

Using merger data covering 1977-1996, Megginson et al find that mergers which increase
focus deliver small but positive abnormal returns. In contrast, focus-decreasing mergers end
up destroying a lot of value (with an abnormal return of nearly -20% over three years).

Performance of focus increasing/decreasing M&A (abnormal returns, %)

-5

-10

-15 Focus Increasing

Focus Decreasing

-20

-25
Year 1 Year 2 Year 3

Source: Megginson et al, SG Equity Research

Megginson et al also show that focus-increasing mergers are more likely to generate positive
long run returns, with 50% of such mergers generating positive returns. With focus-decreasing
mergers, only around 33% generate positive returns to the shareholders.

% of deals adding value

60
Focus Increasing
Focus Decreasing
50

40

30

20

10

0
Year 1 Year 2 Year 3

Source: Megginson et al, SG Equity Research

10
Morgan, Megginson and Nail (2002) The determinants of positive long-term performance in strategic
mergers: Corporate focus and cash

19 November 2008 7
 Mind Matters

One can also look at the performance of de-mergers, which should in general be
focus-increasing, to see if this confirms the focus story. Kirchmaier 11 examined the long-term
performance of 48 European de-mergers between 1989-1999. After three years, the combined
performance of parent and spin-off was an abnormal return of 4.2%. The spin-out itself delivered
an abnormal return of 17%, whilst the parent generated an abnormal return of -5.9%.

One of the issues related to focus-increasing M&A is, of course, pricing power. In industries
that face fierce competition (or indeed in the face of outright deflation) firms may seek to
consolidate in order to protect (or increase) their pricing power. This is certainly the lesson
from Japan. Domestic M&A has remained relatively robust despite a nearly two-decade long
bear market. This activity has been driven by attempts to maintain prices.

From an investors’ perspective it remains a moot point as to whether owning a business in

such an industry is a good idea. It may be better to own the stocks that are being
consolidated rather than the consolidator.

All of which suggests that contrary to popular corporate management perceptions, M&A based
on ‘focus increasing’ rather than diversification is more likely to add value (or at least to limit the
scale of the value destruction).

Cash is king
Investors should also pay attention to the manner in which the merger or acquisition is being
financed, as this provides important evidence as to the likely benefits to shareholders.

Megginson et al show that mergers that are financed by cash are significantly better news for
investors than those that are entirely stock financed, The chart below shows the returns over
time for all cash and all stock-financed mergers. Cash-financed deals generally created small
amounts of value for shareholders. In contrast, those deals that are financed by pure stock
destroyed very significant amounts of value.

Performance by financing style (abnormal returns, %)

10

-5

-10

-15 All cash

All stock
-20

-25
Year 1 Year 2 Year 3

Source: SG Equity Research

11
Kirchmaier (2003) The performance effects of European Demergers

8 19 November 2008
 Mind Matters

We can combine the focus increasing/decreasing aspect and the financing aspect to help
differentiate between good and bad deals. As the chart below shows over the long term,
focus-increasing deals which are cash financed can actually add value to investors. At the
opposite end of the spectrum, stock-financed, focus-decreasing mergers can make for very
attractive shorting candidates.

Combining focus and financing (abnormal returns, %)

20

10

-10

-20
Cash focus increase
-30
Cash focus decrease

-40 Stock focus increase

Stock focus decrease
-50
Year 1 Year 2 Year 3

Source: SG Equity Research

Hot or cold
Merger activity often seems to come in waves (or occur in clusters if you prefer). The evidence
suggests that investors should strive to be contrarian in their support for mergers. That is to
say, when mergers are in fashion, investors should shun them like the plague, and conversely
when no one wants to contemplate any corporate activity investors should support corporates
that are willing to engage in mergers and acquisitions.

Global M&A waves (value of M&A, US$mn)

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: SG Equity Research

Using data from the US from 1974-2004, Yan 12 shows that mergers conducted in periods
when few are willing to follow this path tend to provide significant returns to shareholders. In

12
Yan (2006) Merger Waves: Theory and Evidence

19 November 2008 9
 Mind Matters

contrast, when everyone is busy merging, the returns to investors are severely disappointing.
So avoid M&A driven by fads and fashions.

Abnormal performance of M&A by popularity of M&A

20

15

10

-5

-10
Cold 2 3 4 Hot

Source: Yan, SG Equity Research

On a related issue, Bouwman et al 13 show that M&A which is conducted when the market
overall is relatively cheap is much better news for investors than M&A conducted when the
market is expensive. They define expensive markets as the top half of months when the de-
trended PE is above its average. Conversely, cheap markets are the months in which the de-
trend PE is below its average.

During periods of generalised expense (the top half), on average M&A creates negative
abnormal returns of -11%, with cash-financed M&A generating -10%, and stock-financed
M&A showing a -13% return over three years. In contrast, during periods of generalised value
(the bottom half), overall M&A created a positive return of 4.4%, with cash-financed M&A
generating an 8% return, and even stock-financed M&A delivering 5% over three years!

M&A: three-year returns in different market environments (1979-1998)

10 Low valuations
High valuations

-5

-10

-15
All Cash Stock

Source: Bouwman et al, SG Equity Research

13
Bouwman, Fuller and Nain (2003) The performance of stock-driven acquistions

10 19 November 2008
 Mind Matters

All of this suggests that investors should take special care when dealing with M&A that is being
conducted against a backdrop of expensive markets.

Public or private
Another aspect of M&A that has links to the market’s general ‘temperature’ concerns the fact
that much of the value destruction we have witnessed comes from some very high profile
failures involving public companies. Moeller et al 14 note that: “While 48.3% of acquisitions
from 1998 through 2001 are acquisitions of private firms, 75.9% of the large loss deals are
acquisitions of public firms”. So, investors should be more tolerant of M&A involving private
rather than public firms.

Compensation matters
Given that in many ways this note is really all about corporate governance, it is fitting that the
last aspect of it I wish to examine concerns the topic of management compensation.

If an M&A deal includes an earn-out whereby the management’s payout is tied to meeting
future operational performance benchmarks then, unsurprisingly, M&A doesn’t seem to
damage long-term shareholder returns 15.

The diametric opposite of an earn-out is the M&A bonus. Grinstein and Hribar 16 show that
39% of firms pay CEOs a cash bonus at the completion of an M&A deal – a perfect way to
ensure that shareholders stand a good chance of losing money!

Grinstein and Hribar show that CEOs with more power to influence the board receive larger
bonuses. CEOs with more power also tend to engage in larger deals than their peers.
Grinstein and Hribar only examine short-term returns, but that is better than nothing
(especially since initial moves often set the tone for future longer-term returns). The average
two-day announcement period return is -1.5% in their sample. For those firms where
managers have more power (and hence higher bonuses) the return drops to -3.8%.

So, effectively, investors should examine the detail of the M&A and check the incentives available
to managers. Contracts that are operational performance-related seem to encourage responsible
behaviour, whilst M&A completion bonuses seem to encourage exactly the opposite.

Conclusions
All of these areas can be pulled together to provide investors with a checklist that might help serve
as a guide to the likely scale of value destruction that any given M&A deal might unleash.

The ‘ideal deal’ from an investor’s perspective (and let’s remember investors are the owners of
the business, the managers are just that, the hired help) is a cheap private firm with good
governance as a target, with an acquirer motivated by increasing focus and cost-cutting

14
Moeller, Schlingemann and Stulz (2003) Wealth destruction on a massive scale? A study of acquiring
firms returns in the recent merger wave

15
Kohners and Ang (2000) Earnouts in mergers, Journal of Business

16
Grinstein and Hribar (2003) CEO compensation and incentives – evidence from M&A bonuses

19 November 2008 11
 Mind Matters

synergies who pays managers based on performance and who wants to use surplus cash to
finance the deal. The deal should occur at a time when the market is generally relatively
cheap, and M&A is highly unfashionable.

In contrast the nightmare scenario is an expensive public firm with poor governance as a
target, being bid for by an acquirer motivated by ‘empire building’ diversification hooked on
repeated M&A and dreaming of revenue synergies. This deal would be financed purely by
stock, and the managers would be rewarded by a completion bonus. Such a deal would also
occur when the market was generally expensive, and when M&A was the flavour of the month.

Of course, these two cases represent the extremes. Often investors will be required to balance
elements from both sides of the table below. But, as long as there more elements from the
left-hand side, then the value destruction should hopefully be limited. In contrast, if factors on
the right-hand side of the table dominate, then investors should be especially leery.

The good, the bad and the ugly: what to look for in M&A?
Good' M&A Bad' M&A
Value Growth
Cash financed Stock financed
Increasing focus Diversifying
Cold markets Hot markets
Cheap markets Expensive markets
Cost cutting synergies Revenue synergies
Earn-outs Completion bonuses
Private target Public target
Source: SG Equity Research

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12 19 November 2008