Aligning Deal Price With Value Potential: Overpayment can curse a deal from Day 1

Deal fever is raging again, and more companies around the world are looking to join forces. But with the fever can come the curse – “the winner’s curse.” This is the chance that, in the throes of deal delirium, companies overestimate potential synergies and/or get swept up in the deal momentum, consequently overpaying for their acquisitions. What’s the antidote? For starters, match the price to the target’s potential for creating value. The curse is common and potentially ruinous. Those who suffer the curse may be punished by capital markets, hamstrung competitively, and constrained by burdensome capital structures. At a minimum, they will spend years searching for new ways to meet financial goals and trying to justify their buys. However, there are ways for companies to more accurately spot both the potential and the pitfalls associated with a prospective acquisition. Whether it’s a megadeal, a bolt-on acquisition, or a multi-step transaction over time, mergers and acquisitions can be a viable way to create significant corporate value. Achieving that value, to reiterate, begins by meeting the daunting challenge of matching the purchase price to the target’s value-creation potential. Here are some observations and suggestions for achieving high performance by avoiding the winner’s curse: The “Pre-Cursers” What causes the winner’s curse? Buyers don’t want to overpay and most fully understand that paying too much causes myriad long-term problems. Nevertheless, they frequently falter in these key areas: Separating price from value The intrinsic value of a target company is a function of its future free cash flows, predicated on how it coverts market position, organization, capital, and other assets into performance. Generally, intrinsic value is measured by discounted cash flows, which is supplementary to, but different from, multiples analyses. The net value of a target company reflects the combined net synergies – the acquisition’s pluses subtracted by its minuses, e.g., transaction costs, costs associated with disruption to business-as-usual, severance pay, etc. Price is the final amount paid for a target, after negotiations (see Figure 1). An acquirer overpays when it shells out more than the sum of the target’s standalone cash flows plus the net value of the captured synergies. When overpayment occurs, the acquirer has little choice but to frantically and often futilely seek more synergies. Estimating synergies accurately Often the buyer’s assessments of potential synergies are too informal – too “back-of-the-envelope.” Lacking the bandwidth or the skills to calculate benefits effectively, some companies default to a percentage of valuation yardstick, without relying on extensive hard data or detailed market analyses. This is particularly common in estimating the potential revenue synergies of the two organizations, or how much additional net revenue can be generated by the combination. However, it’s also prevalent in estimating cost synergies. Checking the work Many buyers believe that their initial assumptions about a deal’s fit, rationale, structure, and valuation do not need to be revisited once the deal closes. This is foolish. As business conditions change, a company’s understanding of the acquisition’s benefits evolves. First-pass assessments often are not rigorous enough to capture these changes, especially when they are unforeseen. Retaining perspective Adrenaline, personal agendas, and the tendency to be swept up by the wave of competitive bids are common as a deal moves toward the finish line. But any of these drivers can push the deal price to unrealistic levels. Such heat-of-the-moment budget-busters are particularly common in auctions. But surprisingly, they also crop up in one-on-one negotiations, such as when acquirers are tempted to offer a blow-out price to preclude shopping by the target. The Complications Besides depressing share price and eroding investor support, overpaying for an acquisition destroys value that may be impossible to recoup. An overpriced deal diverts funds and energy from the rest of the business. This discourages growth and innovation, curtails the newly merged company’s ability to make other business moves, and leaves it more vulnerable to rivals eager to aggressively capitalize on the buyer’s weakness. Most ironically, overpaying compromises the company’s ability to pursue a better-placed acquisition that might have helped the company achieve its strategic goals. Exorbitant purchase prices also overload the acquirer’s capital structure – producing too much debt or diluting equity. In extreme cases, irresponsible buys can even expose the company to regulatory or compliance problems. Guarding Against the Winner’s Curse Once a buyer has been infected, there’s no cure for the winner’s curse. But there are ways to shield against the curse. Protection consists of four components: * People * Processes * Perspective * Preparation People It’s critical that the right skills be deployed to each area of the deal. For example, a team member who understands the science in a mid-cap pharmaceuticals acquisition may not be the right person to determine the range of intrinsic values for the target company. That person might help to determine strategic fit, but to avoid overpaying, someone with deal experience and financial know-how is needed to perform value assessments. Interconnected teams also are vital. Deal teams generally include a few deal-experienced personnel or perhaps the company’s business development group. Ensuring cross-functional pre-deal expertise and involving the people who will staff the post-merger integration teams are essential. After all, they are among the best qualified to identify areas where significant value creation can be garnered. Including the integration and other appropriate teams also helps the buyer discover other issues that could influence the purchase price, such as possible inability to integrate the manufacturing lines of the two businesses. Processes Numerous process-related issues affect the deal price and consummation. For example, M&A strategy should basically be a process that includes developing standardized, repeatable, measurable mechanisms for creating and pursuing deals, managing multiple deals in the pipeline and across business units at the same time, and identifying alternate ways to seek external growth. Another issue is target screening, which includes processes for identifying, assessing, prioritizing, and evaluating the right targets while recognizing and quantifying deal alternatives. Courtship of a target also might be considered a process since its elements include knowing how and when to approach an acquisition candidate and understanding the balance involved in wooing a potential target versus negotiating with its principals. Often, a different team that is more relationship-oriented leads the courtship process before giving way to the most skilled and value-oriented negotiators. Lastly, there’s due diligence executed through strategic, operational, and financial processes with the mission of ensuring that: * The right strategic fit exists; * The business plan reflects the reality of the target’s contributions, something particularly vital because management optimism, differences in accounting methodologies, and even liberties with financial statement “geography” can create a distorted pictures of the target’s prospects; * Assumptions about the target’s operations mesh with the buyer’s understanding of its potential, including assessment of such assets as correct product portfolio combinations, marketing capabilities, and IT infrastructure support; * Capital investment levels, R&D capabilities, and sales, general, and administrative (SG&A) and other support costs are in line with the acquirer’s vision of what it will take to grow the combined business; and * Cost allocations have been accurately reflected across divisions, which is highly germane if the acquirer is buying only part of a seller’s operations or if certain divisions at the target generate significantly greater synergies than others. A good example of getting the diligence process in a key strategy-shaping deal right is Kellogg Co., which by the late 1990s had lost its market-leading position in its core cereals business and 20% of its share price despite a booming economy. Kellogg executives set out to reestablish the company’s competitive edge by bolstering its presence in the snack category. Because Kellogg lacked access to a direct snack-distribution channel, it opted to acquire one, and targeted Keebler Foods Co., a leading U.S. cookie and cracker maker, which seemed to have a direct-store delivery model that would meet Kellogg’s distribution needs. During deal execution, which was completed in 2001, Kellogg refined its due diligence to focus on the most important drivers of the target’s value – Kellogg’s fit with Keebler’s direct-store distribution system and how the savings would help offset the cost of the deal. With the hard numbers and a clear plan in hand, Kellogg went on to exceed its synergy estimates, create significant value through the deal, and avoided the winner’s curse. Within a year, Kellogg’s stock rose more than 25% and the company again began to outperform its competitors. Perspective In the heat of the deal, particularly in competitive situations, discipline is critical. The primary deal negotiator for the buyer should know the company’s critical walk-away price and stick to it. Basically, the walk-away price should be set at a point well below the upper limit of the buyer’s value-creation zone (see Figure 1), since value is created only when intrinsic value plus net synergies actually exceed the purchase price. A good practice is to start negotiating at a rate below that walk-away price, thus ensuring wiggle room to step up the offer as negotiations move forward. Failing to adhere to the walk-away price can be devastating. Budging a few percentage points on a large deal often translates into hundreds of millions of dollars left on the table, or puts pressure on the buyer to squeeze out additional synergies to reach its value-creation goals. Rules of thumb, e.g., paying 30% above the market value, should not be used to determine the purchase price. Instead, the pricing parameters of every deal should be formulated individually. In a deal environment – where it’s easy to get carried away – it’s always better to negotiate based on thorough, pragmatic estimates as opposed to feel-good judgments designed to get the deal done at any price. One key rule that can be rigorously applied, however, is don’t pay for it unless you can value it. Many companies correctly review the cash flow projections of a target to calculate the intrinsic value. However, some mistakenly separate their valuations of the target from the strategic value of the deal. They might assume that “although the value of the target is $5 billion, we can pay a lot more because there’s strategic value in acquiring the asset.” This may be true up to a point, but the “softer” elements, such as strategic value, should still be embedded in the value of the deal. For example, a buyer’s potential ability to fend off competition with, say, a new technological advance provided by the target should be factored into the market share and related revenue forecasts of the target. Preparation Knowing the target, its potential deal sensitivities and deal-breakers, and the key components of value provide much of the information the buyer needs to negotiate a good deal. Nevertheless, it still must expect the unexpected. So when something unforeseen happens, the acquirer that is best prepared can respond quickly and appropriately to keep the deal on track, and perhaps even capitalize on the unexpected development. Preparation also includes planning up front for post-merger integration. Despite all advice to the contrary, some companies still are convinced that integration planning can be delayed until after deal closing. Savvy companies know that value creation is accelerated when integration is planned during the deal-execution phase and maybe even sooner. Some components of integration planning include: * Executing the initial communications plan * Setting financial goals and folding them into synergy estimates during due diligence * Identifying the most important tactical issues * Managing customer and employee experiences * Setting cultural objectives, and * Assessing readiness for “Day 1” following the close After Cingular Wireless and AT&T Wireless Services Inc. announced their $41 billion merger in October 2004, they wasted no time in pushing integration. They launched training programs. They staffed call centers with thousands of temporary customer service representatives to handle anticipated spikes in inquiries. They had thoroughly planned numerous long-range elements of the integration process: Everything that could be legally accomplished before Day 1 was accomplished before Day 1. The de novo entity design started shortly after the merger announcement and continued for the eight months leading up to deal close, or following regulatory approval. Cingular’s management later was able to announce “increased operating synergies” and a faster achievement of savings than originally projected. Stamping Out the Curse With widespread discipline and adherence to M&A best practices, the winner’s curse can be eradicated. In fact, there seems to be a trend in this direction – with more than a few companies executing deals with strong potential to maximize synergies and inspire high performance. The trend also seems visible in pricing discipline. Both Procter & Gamble Co. with its Gillette Co. acquisition and Johnson & Johnson in its bid for medical equipment maker Guidant Corp. offered premiums over stock prices that were a fraction of the norm in prior M&A waves, thus promoting standards for avoiding overpayment. For acquirers that are serious about instilling rigor and discipline in their M&A people, processes, perspectives, and preparation, enhanced performance should result. For the less serious and less disciplined…caveat emptor. Milyae Park is a lead for Accenture’s Corporate Strategy/M&A Practice in London. (c) 2005 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com