Multiple studies have revealed that over half of completed M&A transactions actually dilute shareholder value within the first year. In a recent white paper,“Fundamental Issues Surrounding Failed Acquisitions” (April 2002), co-authors Robert Stefanowski and Anshuman Ray explore the underlying environmental factors that frequently derail promising corporate pairings.
To investigate the extent to which preacquisition environmental factors affect postacquisition success, the authors examine how changes that occurred during the ’90s in investment banking, public accounting, and the economy in general affected the performance of newly merged companies. They first identified companies that had completed acquisitions valued at $100 million or more; then, on the basis of such factors as pre- and post-transaction stock prices and the amount of time permitted for due diligence, they refined their list of target companies. Finally, using financial data gathered through SEC filings, numerous analysts' reports and their own analysis of key financial ratios, they compared the performances of 25 firms that had merged under significantly different business climates. They thus were able to determine how such often overlooked factors as accounting practices, incentive systems and investor expectations alter M&A outcomes and the ability of managers to subsequently meet the financial objectives of merged entities.
One of the more critical factors they identify is a steady rise in investors' growth expectations as evidenced by the gradual rise in the premiums paid for acquired assets during the late ’90s. As earnings expectations rose, they became increasingly difficult to meet within established business frameworks. For example, First Union's 1998 acquisition of Money Store led to a $1.8 billion restructuring charge two years later and the loss of more than half of First Union's market value.
Meanwhile, the strong economy of the ‘90s and the liquidity it created led to an escalation in the value of M&A transactions by an average of 18% annually. In 1998, for example, Conesco Finance paid seven times net worth to acquire the assets of Green Tree Financial, a $6.6 billion premium to book value. High acquisition premiums (the difference between the purchase price and the book value of the assets being acquired), in turn, m ade solid earnings growth increasingly difficult to achieve, even in a strong economy. Conesco's pre-acquisition net income of $2.27 per share in 1997 turned into a net loss of $3.69 per share by 2000. Increasing liquidity also led investment bankers to become more offhanded toward deal making. The time they allowed for buyers to complete the due diligence process, for example, declined to an average of just two days. This condition was exacerbated by incentive compensation plans that rewarded bankers and other M&A professionals on the basis of the quantity, not quality, of the deals they closed.
The authors identify two other environmental changes affecting acquisition success: an increased use of aggressive accounting techniques and a trend toward using stock as transaction currency. By using stock, firms avoided incurring significant amounts of new debt and their typically high share prices often made deals seem more like bargains than they really were. For instance, when Internet grocer Webvan acquired rival Homegrocer in September 2000, it issued 138 million shares of common stock to retire all Homegrocer shares. While the move incurred more than $900 million in goodwill, Webvan was able to complete the transaction without incurring new debt or interest expense.
On the basis of their study, Stefanowski and Ray offer recommendations on how to minimize the risk of acquisition failure. They advocate critical reviews of due diligence findings by independent management teams and the conducting of independent audits when sales are closed and annually thereafter. In addition, the authors identify two measures to reduce the risk associated with inadequate due diligence periods and the use of aggressive accounting. First, buyers should negotiate “tight” purchase agreements that “ensure proper representations by and indemnities from the seller” regarding liabilities that may be unknown to the buyer when closing the transaction. Second, because M&A agreements can take months to negotiate, buyers should insist that the purchase agreements, which typically precede them, include a clause that protects against unexpected changes that might adversely affect the target company's value during the intervening period.
Stefanowski is the managing director in charge of GE Capital Merchant Banking Group's New York office and an adjunct professor in M&A at New York University's Stern School of Business. Ray, a 2002 MBA graduate of Boston College, has experience in corporate development and private equity.