The Synergy Trap

THE SYNERGY TRAP

THE SYNERGY TRAP

How Companies Lose the Acquisition Game

MARK L. SIROWER

THE FREE PRESS

THE FREE PRESS

A Division of Simon & Schuster Inc.

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New York, NY 10020

Copyright © 1997 by Mark L. Sirower

All rights reserved, including the right of reproduction in whole or in part in any form.

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Manufactured in the United States of America

10

Library of Congress Cataloging-in-Publication Data

Sirower, Mark L., 1962-

The synergy trap: how companies lose the acquisition game / Mark L. Sirower.

p.   cm.

Includes index.

1. Consolidation and merger of corporations—United States. 2. Tender offers (Securities)—United States.   3. Management buyouts—United States.   4. Competition—United States. 5. Risk—United States.   I. Title.

HD2746.55.U5S57   1997

338.8′3′0973—dc20   96-44862

CIP

ISBN-13: 978-0-6848-3255-5

eISBN-13: 978-1-4391-3770-3

www.SimonandSchuster.com

To Mom and Dad

You will always be my greatest teachers

Contents

Preface

PART 1. UNCOVERING THE RULES OF THE GAME

1. Introduction: The Acquisition Game

The M&A Phenomenon

Back to First Principles: The Acquisition Game

A Brief History of the Research on Acquisitions

2. Can You Run Harder? Synergy

Synergy and the Acquisition Game

The Performance Requirements of Pre-Acquisition Market Values

The Competitive Challenge of Synergy

The Cornerstones of Synergy

Predictable Overpayment

3. Do You Feel Lucky? The Acquisition Premium

The Synergy Concept: Expectations versus Realizations

The Resource Allocation Decision: An Introduction

Required Performance Improvements: A Simulation Approach

The Seductiveness of Financial Valuation Models

4. Tools and Lessons for the Acquisition Game

Prior Expectations and Additional Resource Requirements

Competitors

Time, Value, and the Premium

PART 2. AN ANALYSIS OF CORPORATE ACQUISITION STRATEGIES

5. Acquirer Performance and Risk Taking

Corporate Acquisitions as a Strategy for Value Creation

Acquisition Premiums

Strategic Relatedness of Acquisitions

Method of Payment

The Performance Effects of Mergers versus Tender Offers

Relative Size of the Acquisition

Managerial Risk Taking Following Acquisition

6. Methodology

Sample

Acquiring Firm Performance

Independent Variables

Changes in Risk Taking Following Acquisition

Empirical Techniques

7. Discussion of Results

Aggregate Results on Acquisitions

Traditional Tests and Replications of Evidence on Relatedness

Testing the Acquiring Firm Performance Model

Tests for Changes in Risk Taking

8. Implications of the Analysis

Theoretical Contributions

Public Policy Implications

Practical Implications

Appendix A: Review and Critique of Prior Research on Mergers and Acquisitions

Appendix B: Detailed Results of the Analysis in Part 2

Appendix C: Sample and Descriptions of Targets and Acquirers Used in the Analysis

Notes

Bibliography

Index

About the Author

Preface

The M&A wave of the 1980s has become the tidal wave of the 1990s. In 1999 alone, merger and acquisition announcements totaled over $3 trillion. Although much has been written over the past three decades about these major corporate investment decisions, the fundamentals of acquisition performance have remained a mystery.

This book grew out of my doctoral research and through a course I developed, called The Management of Corporate Merger and Acquisition Strategies, for MBAs and executives at Columbia Business School. The objective of the book is to break down the walls between finance and strategic management—and to expose the foundations of performance—in the vitally important area of acquisitions. Indeed, it is precisely the walls dividing the two fields that have given rise to unexamined and misleading folklore about the so-called keys to acquisition success.

Most prior research on mergers and acquisitions has reflected the divisionalized nature of business schools. Financial perspectives have ignored the competitive and organizational realities, and strategic management perspectives have been devoid of the finance so essential for an understanding of the value of investment decisions. A major result is that synergy has remained a vague and even mysterious concept—with little financial or strategic meaning. Unfortunately, in practice the use of sophisticated valuation models, combined with a poor understanding of what, exactly, synergy is, has caused the justification of many predictably bad acquisitions and the destruction of billions of dollars of shareholder value in acquiring firms.

Amid all the excitement surrounding M&A activity, it is easy to forget that acquisitions are strategic alternatives. CEOs, executive teams, and boards of directors readily choose acquisitions over other investment alternatives, paying substantial premiums in the process. They often fail to consider that it is incorrect to judge the soundness of an acquisition decision on the basis of what it would cost the company to develop that particular business from scratch—an idea that may have been a value-destroying decision on its own. In fact, acquisitions are unique alternatives and the success of these strategic decisions must be judged by their effects on the wealth of the owners—the shareholders—of the acquiring company.

It is the payment of an acquisition premium that sets up the unique business gamble that acquisitions represent. The premium forces a consideration of the performance already embedded in preacquisition share prices and the improvements in performance that will be required. In turn, these considerations give rise to the precise meaning and the competitive nature of synergy itself—a major component of this book.

When I first became interested in studying the managerial significance of the acquisition premium as a doctoral student at Columbia over seven years ago, a senior strategy professor challenged my ideas by saying, Acquisition premiums are not a management issue—that’s a finance topic. Although I knew this meant there would be a struggle ahead, the statement assured me there was an important opportunity to get to the heart of acquisition performance. The book is the result of a long journey. I hope the fundamentals of the acquisition game developed herein will set the stage for more thoughtful acquisition decisions and for future scholarly work on acquisition strategies.

The book is divided into two parts, beginning in rather shallow water and getting deeper as the book progresses. Part 1 presents the elements of acquisition performance, developing the competitive principles behind synergy and the economics of the acquisition premium. In particular, Chapter 4 integrates and extends the financial and strategic concepts presented in Part 1 and gives useful tools and lessons for anyone involved in acquisition decisions. This chapter is essentially a short course for managers, directors, investment bankers, and consultants involved in acquisitions.

Part 2 presents an extensive analysis of the performance of corporate acquisition strategies, incorporating and examining the elements of Part 1. Chapter 6, which details the methodology behind the study, can be bypassed by the manager who wants to get right to the discussion of the results in Chapter 7. Finally, Chapter 8 discusses the implications and contributions of the two parts of the book.

There are a number of people I would like to acknowledge for their contributions and support while I completed the book and the research behind it. First, I owe a very special thanks and an intellectual debt of gratitude to industrial-organization economist Dennis C. Mueller and the legendary chairman and CEO of Cooper Industries, Robert Cizik. Their contributions, over the past thirty years, to the academic literature and to the practice of acquisitions, respectively, have had a major impact on my thinking on acquisitions. In addition, I benefited greatly from their comments, advice, and encouragement during the process of writing the book.

I must thank my professors at Columbia University who allowed me the opportunity to pursue interdisciplinary work during my years in the business school. Ellen Auster, Warren Boeker, James Freeman, Kathryn Harrigan, Gailen Hite, and Boris Yavitz gave encouragement when this book was only ideas. Gailen Hite, my mentor and friend, guided me through the demands of the research on which this book is based. It will always be an honor to have worked with a scholar of his integrity. I am grateful to Kathryn Harrigan for encouraging me to transform this research into a book and, particularly, to publish with The Free Press. On both counts, it was truly a rewarding experience.

I also must thank my colleagues in the management department at the Stern School of Business at NYU for their support for the writing of this book. In particular, I must thank William Guth, Robert Lamb, and William Starbuck for convincing me to take the underlying research and open the ideas to managers. I am also grateful to my colleagues Rikki Abzug and Joseph Lampel for countless hours of helpful advice during the project. Karen Angelillo and Li Yang provided invaluable administrative support throughout.

In the process of presenting pieces of this work in various stages of development at universities and to executives, several people gave many insightful comments and suggestions. As with so many things in life, it is those little things here and there that add up over time. These people include: Bernard Black (Columbia Law School), Glynn Bolar (AT&T), David Collis (Harvard Business School), Bruce Greenwald (Columbia Business School), Philippe Haspeslagh (INSEAD), Robert Klemkosky (Indiana), Keith Kostuch (The Boston Consulting Group), Stephen O’Byrne (Stern Stewart & Co.), Jeff Phillips (Coopers & Lybrand), Mark Shanley (Northwestern), L. G. Thomas (Emory), Sheridan Titman (Boston College), Jeff Salzman (CS First Boston), Harbir Singh (Wharton), Nikhil Varaiya (San Diego State), Theo Vermaelen (INSEAD), and Feng Ye (Deutche Morgan Grenfell).

The professionals at The Free Press deserve extensive credit. I owe a large debt of gratitude to my editor, Robert Wallace, for his confidence in this project and for pushing its timely completion. Fortunately, he is surrounded by first-rate professionals. Dewey Brinkley, Iris Cohen, and Loretta Denner were instrumental in improving the quality of this work and seeing it through to completion. Loretta, in particular, was practically part of the family during the final months of production. Her patience and attention will always be remembered.

To my wife, Yaru: Although I do not know if I can stop talking about M&A, I will try to use the words synergy and premium less often. This book could never have happened without your love and support. I promise to get a much bigger up-front advance next time. Finally, this book is dedicated to the memory of my parents, who lovingly preached the values of integrity, honesty, determination, and perseverance. I hope this book reflects their teachings.

Mark L. Sirower New York, New York

Part 1

UNCOVERING THE RULES OF THE GAME

1

Introduction: The Acquisition Game

Many managers were apparently over-exposed in impressionable childhood years to the story in which the imprisoned, handsome prince is released from the toad’s body by a kiss from the beautiful princess. Consequently they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price they’d pay if they made direct purchases on their own? In other words investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses better pack some real dynamite. We’ve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.

—Warren Buffett, 1981 Berkshire Hathaway Annual Report

The 1990s will go down in history as the time of the biggest merger and acquisition (M&A) wave of the century. Few, if any, corporate resource decisions can change the value of a company as quickly or dramatically as a major acquisition.

Yet the change is usually for the worse.

Shareholders of acquiring firms routinely lose money right on announcement of acquisitions. They rarely recover their losses. But shareholders of the target firms, who receive a substantial premium for their shares, usually gain.

Here’s a puzzle. Why do corporate executives, investment bankers, and consultants so often recommend that acquiring firms pay more for a target company than anybody else in the world is willing to pay? It cannot be because so many acquisitions turn out to be a blessing in disguise. In fact, when asked recently to name just one big merger that has lived up to expectations, Leon Cooperman, the former cochairman of Goldman Sachs’s investment policy committee, answered, I’m sure that there are success stories out there, but at this moment I draw a blank.¹

It doesn’t make sense. For over thirty years, academics and practitioners have been writing books and articles on managing mergers and acquisitions. Corporations have spent billions of dollars on advisory fees. The platitudes are well known. Everyone knows that you should not pay too much for an acquisition, that acquisitions should make strategic sense, and that corporate cultures need to be managed carefully. But do these nostrums have any practical value?

Consider. You know you’ve paid too much only if the acquisition fails. Then, by definition, you have overpaid.

But how do we predict up front whether a company is overpaying for an acquisition—in order to prevent costly failures? What exactly does the acquisition premium represent, and when is it too big? What is the acquirer paying for? These are the details, and the devil is in them.

This book returns to first principles and precisely describes the basics of what I call the acquisition game. Losing the game is almost guaranteed when acquirers do not realize that acquisitions are a special type of business gamble.

Like a major R&D project or plant expansion, acquisitions are a capital budgeting decision. Stripped to the essentials, an acquisition is a purchase of assets and technologies. But acquirers often pay a premium over the stand-alone market value of these assets and technologies. They pay the premium for something called synergy.

Dreams of synergy lead to lofty acquisition premiums. Yet virtually no attention has been paid to how these acquisition premiums affect performance. Perhaps this is because the concept of synergy itself has been poorly defined.

The common definition of synergy is 2 + 2 = 5. This book will show just how dangerous that definition is. Pay attention to the math. The easiest way to lose the acquisition game is by failing to define synergy in terms of real, measurable improvements in competitive advantage.

A quantifiable post-merger challenge is embedded in the price of each acquisition. Using the acquisition premium, we can calculate what the required synergies must be. Often this calculation shows that the required performance improvements are far greater than what any business in a competitive industry can reasonably expect.

By analyzing the acquisition premium, we can determine in advance when the price is far above the potential value of an acquisition. We can also show why most purported synergies are like the colorful petals of the Venus flytrap—dangerous deceivers. But managers who analyze the acquisition premium and understand the concept of synergy will not get caught. They can predict the probability and the amount of shareholder losses or gains.

My claim is that most major acquisitions are predictably dead on arrival—no matter how well they are managed after the deal is done.

The M&A Phenomenon

Mergers and acquisitions are arguably the most popular and influential form of discretionary business investment. On the single day of April 22, 1996, with the announcement of the Bell Atlantic—NYNEX merger and Cisco Systems’ acquisition of Stratacom, over $27 billion of acquisitions were announced. For 1995, the total value of acquisition activity was over $400 billion—for 1997, over $1 trillion.² By comparison, in the aggregate managers spent only $500 billion, on average, over the past several years on new plant and equipment purchases and a mere $130 billion on R&D.³

Acquisition premiums can exceed 100 percent of the market value of target firms. Evidence for acquisitions between 1993 and 1995 shows that shareholders of acquiring firms lose an average of 10 percent of their investment on announcement.⁴ And over time, perhaps waiting for synergies, they lose even more.⁵ A major McKinsey & Company study found that 61 percent of acquisition programs were failures because the acquisition strategies did not earn a sufficient return (cost of capital) on the funds invested.⁶ Under the circumstances, it should be natural to question whether it is economically productive to pay premiums at all.

Logically, we should expect that managers choose an acquisition strategy only when it offers a better payoff than other strategic alternatives. But there are several pitfalls inherent in acquisitions because they are, in fact, a very unique investment.

First, since acquirers pay a premium for the business, they actually have two business problems to solve: (1) to meet the performance targets the market already expects, and (2) to meet the even higher targets implied by the acquisition premium. This situation is analogous to emerging technology investments where investors pay for breakthroughs that have not yet occurred, knowing that competitors are chasing the same breakthroughs. However, in acquisitions, the breakthroughs are called synergies.

I define synergy as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently. In other words, managers who pay acquisition premiums commit themselves to delivering more than the market already expects from current strategic plans. The premium represents the value of the additional performance requirements.

Second, major acquisitions, unlike major R&D projects, allow no test runs, no trial and error, and, other than divesting, no way to stop funding during the project. Acquirers must pay up front just for the right to touch the wheel.

Finally, once companies begin intensive integration, the costs of exiting a failing acquisition strategy can become very high. The integration of sales forces, information and control systems, and distribution systems, for example, is often very difficult to reverse in the short term. And in the process, acquirers may run the risk of taking their eyes off competitors or losing their ability to respond to changes in the competitive environment.

Legendary and successful acquirers such as Bestfoods, Cooper Industries, and Emerson Electric have learned over time and implicitly understand the fundamentals of the game.⁷ But most companies make very few major acquisitions and often hire outside advisers to do the acquisition valuations (called fairness opinions). A Boston Consulting Group study found that during the pre-merger stage, eight of ten companies did not even consider how the acquired company would be integrated into operations following the acquisition.⁸ It is no wonder that often the acquirer loses the entire premium—and more. Escalating the commitment by pouring more money into a doomed acquisition just makes things worse, perhaps even destroying the acquirer’s preexisting business.

The objective of management is to employ corporate resources at their highest-value uses. When these resources are committed to acquisitions, the result is not simply failure or not failure. Instead there is a whole range of performance outcomes.

Shareholders can easily diversify themselves at existing market prices without having to pay an acquisition premium. My analysis in this book shows that acquisition premiums have little relation to potential value and that the losses we observe in the markets to acquisition announcements are predictable. What do acquiring firm executive teams and advisers see that markets do not?

The most obvious answer to this question is synergy, yet anecdotal evidence suggests that managers are somewhat reluctant to admit that they expect synergy from acquisitions. In the battle for Paramount, synergy became the embarrassing unspoken word. And Michael Eisner has stated that he does not like to use the s word regarding Disney’s acquisition of CapCities/ABC.⁹ So why do these executives pay premiums? Is it that those who do not remember the past are thoughtlessly repeating it?

The 1980s set all-time records for the number and dollar value of corporate mergers and takeovers in the United States, firmly displacing the famous merger wave of the 1960s. More than 35,000 deals worth almost $2 trillion were completed during the 1980s, with the average size of a deal reaching over $200 million in 1988 and 1989.¹⁰ Advisory fees alone totaled over $3.5 billion in the peak years, 1988 and 1989.¹¹

The merger and acquisition field is well established. Since 1980, managers have allocated over $20 billion to investment banking and other advisory fees to help formulate and ensure the success of their acquisition strategies. In addition to professional advisers, there are academic courses: leading universities give week-long seminars to packed houses all over the world, and the American Management Association has an extensive program on M&A. Yet despite all of this advice, many fail.

As Bruce Greenwald, a professor at Columbia Business School has said: Once you see the truth about something it is obvious, but there are many seemingly obvious things that simply are not true. Obvious but untrue advice and folklore about acquisitions has led to bad business decisions. Why in fact do some acquisitions lose more money than others?

Back to First Principles: The Acquisition Game

A bad acquisition is one that does not earn back its cost of capital. Stock market reactions to mergers and acquisitions are the aggregate forecasts of investors and analysts around the world of the expectations of the value of the investment. What does it mean when these sophisticated capitalists bid down the stock of acquiring firms and bid up the stock of targets?

The theory of the acquisition game and the synergy trap is rooted in the Nobel Prize—winning research of Professors Franco Modigliani and Merton Miller (M&M). The M&M propositions and their pathbreaking research on valuation begin with the assumption that the value of a firm (V) is equal to the market value of the debt (D) plus the market value of the equity (E):¹²

V = D + E.

Think of this as an economic balance sheet where the market value of claims (the debt and equity) is a function of the expected earnings stream coming from the assets. You can divide the claims any way you like, but the value of the firm will remain the same. In the words of Merton Miller, Think of the firm as a gigantic pizza, divided into quarters. If now you cut each quarter in half or in eighths, the M and M proposition says that you will have more pieces but not more pizza.¹³

The application of this principle is crucial to understanding what it means for acquiring firms to lose huge chunks of market value following acquisition announcements. When you make a bid for the equity of another company (we will call this the target company), you are issuing claims or cash to the shareholders of that company. If you issue claims or cash in an amount greater than the economic value of the assets you purchase, you have merely transferred value from the shareholders of your firm to the shareholders of the target—right from the beginning. This is the way the economic balance sheet of your company stays balanced.

Markets give estimates of this range of value transfer through changes in share prices. The idea of the transfer of value is the stepping-off point for the development of the acquisition game. In short, playing the acquisition game is a business gamble where you pay up front for the right to control the assets of the target firm, and earn, you hope, a future stream of payoffs. But while the acquisition premium is known with certainty, the payoffs are not. What, then, is synergy?

Investors around the world have already valued the future expected performance of the target firm. That value equals the pre-acquisition share price. These investors’ livelihoods are based on paying what the performance is worth. So synergy must translate into performance gains beyond those that are already expected. Simply put, achieving synergy means competing better. But in current hypercompetitive markets, it is a difficult challenge just to achieve the expected performance that is already built into existing share prices—at a zero premium. What happens when we raise the bar?

Because markets have already priced what is expected from the stand-alone firms, the net present value (NPV) of playing the acquisition game can be simply modeled as follows:

NPV = Synergy ˒ Premium.

Companies that do not understand this fundamental equation risk falling into the synergy trap. To quote G. Bennett Stewart of Stern Stewart & Co., Paying unjustified premiums is tantamount to making charitable contributions to random passersby, never to be recouped by the buying company no matter how long the acquisition is held.¹⁴

It is the NPV of the acquisition decision—the expected benefits less the premium paid—that markets attempt to assess. The more negative the assessment is, the worse the damage is to the economic balance sheet and to the share price. Folklore says that the share price of acquirers inevitably drops on the announcement of acquisitions—but in a properly valued acquisition, that does not have to be true.

To visualize what synergy is and what exactly the premium represents in performance terms, imagine being on a treadmill. Suppose you are running at 3 mph but are required to run at 4 mph next year and 5 mph the year after. Synergy would mean running even harder than this expectation while competitors supply a head wind. Paying a premium for synergy—that is, for the right to run harder—is like putting on a heavy pack. Meanwhile, the more you delay running harder, the higher the incline is set. This is the acquisition game.

For most acquisitions, achieving significant synergy is not likely. When it does occur, it usually falls far short of the