M&A Perspectives

There field of M&A asks a number of questions where often the answer is built on several different perspectives.One of the most important problems yet to be resolved, is what causes mergers to arise in waves? In other words, what dictates the timing of merger activity? Although there are many common elements across the various merger waves; sustained economic growth, low interest rate environment, industry deregulation etc... no one theory definitively explains nor predicts wave occurrence.

Although the fact that this issue remains unresolved does not ring alarm bells, it does have some pretty significant implications for firms. For example, there is ample evidence that suggests that bidders at the start of merger waves generate significantly abnormal and positive returns relative to those who engage in the process towards the end of the wave. Timing in mergers, like all facets of life is extremely important, and just like index traders who tries to minimise costs by trading at appropriate times in the day (where liquidity is at its highest point), firm management time mergers and acquisitions to maximise shareholder value. Given the size of the average investment made by listed companies, poor timing can result in the loss of hundreds of millions if not billions of dollars in shareholder wealth.

Throughout history, there have been six major M&A waves (U.S). Although merger waves are an international phenomenon, common to Europe, Asia and South America, the longest history of merger wave movements can be traced to the U.S. These merger movements describe periods of heightened M&A activity, both across the volume and value of deals. Additionally, they share a commonality across deal structures. For example, the first merger wave involved a significant number of horizontal mergers, whilst the second merger wave was characterised by an abnormal proportion of vertical mergers.

Other common characteristics include periods of high economic growth, favourable stock prices which make the purchasing decision more economical, stock market misvaluations which have serious consequences for the allocation of capital, technological change, legal changes, as well as financing innovations. In looking for theories to explain the merger movement, a number of broad perspectives (both rational and irrational) have been highlighted in the literature. The first of these suggests that M&A waves are a rationalisation of the economic decision problem to make or buy. Where there are industry shocks (e.g. deregulation) and potential synergies become accessible, tilting the decision towards "buy" (rather than make), industry consolidation is a natural outcome. This economic decision also ties neatly into the strategic decision which suggests that waves represent an ideal point in time for firms to acquire capabilities, from production to marketing. The strategic decision is not however, distinctively rational. For example, firms can acquire for the simple reason that it improves their market position. This rent-seeking activity however, is not one that generally leads to any long term competitive advantage.

Other theories, that purport to explain why we have mergers waves, focus on the cost of financing, information asymmetry, and the correction of corporate governance problems. One theory, for example, suggests the over-valuation of stocks and the asymmetry of information between firm management and outside investors fosters the buying decision. Put simply, when prices in the market exceed the insider assessment of value, rational managers can enhance their value by selling stock which can be used to pay for mergers or acquisitions. If we reverse the situation, then one would not expect to see firm management engaging in mergers and acquisitions (and using stock to pay for it) during periods where they believe the firm share price to be undervalued.

One of my favourite passages that addresses this point is described by Warren Buffett in his 2009 Berkshire Hathaway (BH) annual newsletter to shareholders. Here it is:

An Inconvenient Truth (Boardroom Overheating)

Our subsidiaries made a few small “bolt-on” acquisitions last year for cash, but our blockbuster deal with BNSF required us to issue about 95,000 Berkshire shares that amounted to 6.1% of those previously outstanding. Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy.

The reason for our distaste is simple. If we wouldn’t dream of selling Berkshire in its entirety at the current market price, why in the world should we “sell” a significant part of the company at that same inadequate price by issuing our stock in a merger? In evaluating a stock-for-stock offer, shareholders of the target company quite understandably focus on the market price of the acquirer’s shares that are to be given them. But they also expect the transaction to deliver them the intrinsic value of their own shares – the ones they are giving up. If shares of a prospective acquirer are selling below their intrinsic value, it’s impossible for that buyer to make a sensible deal in an all-stock deal. You simply can’t exchange an undervalued stock for a fully-valued one without hurting your shareholders. Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence and short on smarts, offers 1 1⁄4 shares of A for each share of B, correctly telling his directors that B is worth $100 per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders of B will end up owning 55.6% of A & B’s combined assets and A’s shareholders will own 44.4%. Not everyone at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large as his original domain, in a world where size tends to correlate with both prestige and compensation.

If an acquirer’s stock is overvalued, it’s a different story: Using it as a currency works to the acquirer’s advantage. That’s why bubbles in various areas of the stock market have invariably led to serial issuances of stock by sly promoters. Going by the market value of their stock, they can afford to overpay because they are, in effect, using counterfeit money. Periodically, many air-for-assets acquisitions have taken place, the late 1960s having been a particularly obscene period for such chicanery. Indeed, certain large companies were built in this way. (No one involved, of course, ever publicly acknowledges the reality of what is going on, though there is plenty of private snickering.) In our BNSF acquisition, the selling shareholders quite properly evaluated our offer at $100 per share. The cost to us, however, was somewhat higher since 40% of the $100 was delivered in our shares, which Charlie and I believed to be worth more than their market value. Fortunately, we had long owned a substantial amount of BNSF stock that we purchased in the market for cash. All told, therefore, only about 30% of our cost overall was paid with Berkshire shares.

In the end, Charlie and I decided that the disadvantage of paying 30% of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting.

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The final perspective that describes why M&A deals are done on mass suggests that they are driven by irrational behaviour. This can exist in the form of managerial pride (e.g hubris), market manias (or asset bubbles) or even following a bidding at all costs kind of strategy. This kind of behaviour is clearly value destructive in the long term. I'll leave you with one more passage from the BH Annual newsletter 2009...

"I can’t resist telling you a true story from long ago. We owned stock in a large well-run bank that for decades had been statutorily prevented from acquisitions. Eventually, the law was changed and our bank immediately began looking for possible purchases. Its managers – fine people and able bankers – not unexpectedly began to behave like teenage boys who had just discovered girls. They soon focused on a much smaller bank, also well-run and having similar financial characteristics in such areas as return on equity, interest margin, loan quality, etc. Our bank sold at a modest price (that’s why we had bought into it), hovering near book value and possessing a very low price/earnings ratio. Alongside, though, the small-bank owner was being wooed by other large banks in the state and was holding out for a price close to three times book value. Moreover, he wanted stock, not cash. Naturally, our fellows caved in and agreed to this value-destroying deal. “We need to show that we are in the hunt. Besides, it’s only a small deal,” they said, as if only major harm to shareholders would have been a legitimate reason for holding back. Charlie’s reaction at the time: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”

The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you’ll never again do a deal this dumb.”

Yes, the merger went through. The owner of the small bank became richer, we became poorer, and the managers of the big bank – newly bigger – lived happily ever after.