A Primer for Helping Get-Tough Boards Weigh Deals (Honing Supp)

In some mergers there truly are major synergies – though oftentimes the acquirer pays too much to obtain them – but at other times the cost and revenue benefits that are projected prove illusory. Of one thing, however, be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked.” – Warren Buffett, 1997 Much attention has been given to the Enron, WorldCom, Adelphia Communications, Tyco, and Global Crossing scandals that resulted in the landmark Sarbanes-Oxley legislation – and for good reason. Corporate boards must ensure that appropriate procedures are in place to prevent criminal activity by management and produce reliable disclosures to shareholders regarding the financial state of the company. Unfortunately, far less coverage has been given to billions of dollars of losses from poorly informed acquisition decisions that, in the aggregate, have been at least as damaging to investors as the well-known acts of outright fraud. Acquisitions represent capital investment decisions that are many times larger than typical capital investments for which systems, structures, and procedures are in place – and both good and bad deals cannot occur without board approval. Sarbanes-Oxley legislation goes a long way to enumerate procedural requirements for officers and directors of public companies. Unfortunately, the legislation does little to ensure that boards are asking the right questions in m&a deals that can have a material impact on shareholders. After two decades of evidence on the difficulty of creating shareholder value in major acquisitions, it’s time to move toward some standards of prudent oversight on these crucial decisions. In this article, we review the economics of m&a decisions and offer straightforward questions for which boards should demand answers before committing shareholder capital. Although the toothless nature of the business judgment rule will protect directors in virtually all acquisition decisions, boards aspiring to be top performers will want to learn how to be better. Why were so many ill-informed acquisition decisions made? And how can directors be better prepared? Part of the answer is revealed in simply recognizing the sheer volume of deals made in the late 1990s and early in the 21st Century. Ten years ago, it would have been difficult to comprehend the redistribution of global assets that occurred in the largest merger wave ever. In 1999 and 2000 alone, according to Thomson Financial, more than 70,000 acquisitions were announced globally, with a combined value of more than $6.7 trillion. Moreover, these acquisitions came at a fast and furious pace unprecedented in industrial history. Figure 1 plots the shape of the recent merger wave: rapidly increasing activity followed by a steep decline. One critical inference from this is that merger waves occur when companies that haven’t previously done deals start doing them, or when active acquirers start doing more or larger deals. Thus, an important implication of an m&a wave is that the environment is packed with inexperience – either inexperience with any kind of deal or inexperience with the new pace and size of deals. Many major transactions are completed as reactions to the dealmaking environment rather than to carefully developed business strategies. Given the sheer volume of mergers, the reactive nature of many decisions, and the complexity of evaluating individual transactions, many deals were approved by boards that may not have fulfilled their fiduciary duties – particularly the duty of care. Simply put, the board owes the fundamental duties of loyalty and care to its shareholders. The duty of loyalty is that a director must not self-deal at the expense of the shareholders. The duty of care calls for a director to act as a prudent person would and on an informed basis with due deliberation before making or approving a decision. Few, if any, decisions carry as much immediate and ongoing risk to shareholders as a major acquisition. As Enron and other financial-based scandals vividly demonstrated, shareholders are not nameless and faceless but are often a company’s own employees. This is an especially important problem for acquisitions. When a deal is met with a drop in the acquirer’s share price of 5%, 10%, or more, not only do employees – the folks who must make the deal work – lose a significant portion of their pension assets but morale suffers even before the critical task of integration begins. Based on the existing body of knowledge on the performance of acquisitions, we now know enough about the economics of acquisitions to call for a standard of prudence with regard to how boards must represent shareholders in these highly risky decisions. There are simply too many great companies that have grown successfully using m&a – for example, General Electric Co., Wells Fargo Corp., International Business Machines Corp., Automatic Data Processing Inc. – to ignore the breakdown in governance that occurs when poorly informed boards weigh acquisitions. Based on the results of a recent study we conducted (see sidebar, “Returns from the Merger Boom”) and interviews with many successful acquirers, we offer five fundamental premises that we believe should be touchstones for senior management and boards that are considering – and debating – m&a as part of a successful growth strategy: * A successful acquisition must enable a company to both beat competitors and reward investors. * Successful corporate growth processes must enable a company to find good opportunities and avoid bad ones at the same time. * Prepared acquirers are not necessarily active acquirers. * A good postmerger integration will not save a bad transaction but a bad integration can ruin a good deal – i.e., one strategically sound and realistically priced. * Investors are vigilant and smart – they can smell a poorly considered transaction right from the announcement. Perhaps the most important takeaway from our study is the required respect for investor intelligence regarding m&a decisions. Initial reactions by investors to transaction announcements are highly indicative of future returns, particularly when the vote is thumbs down. Investor reactions set a critical tone that the company – and its employees – must live with while they attempt to make a deal work. The often-heard suggestion that initial market reactions are meaningless – or just short-term – is, on balance, a myth. Boards should exercise extreme caution when they are presented with a proposed deal that management concedes will hurt investors at the announcement. Performance fundamentals of m&a It is often claimed that getting a deal done is a lot easier than making it work. The implication is that the integration phase will be the key determinant of success or failure. The problem with this thinking is that it ignores the importance of the up-front economics that ultimately drive the performance needs and the likelihood that the integration effort will succeed. Unfortunately, most major deals that ultimately fail are predictably dead on arrival no matter how they are managed after closing. The economics often make little sense from the outset. Successful postmerger integration depends on a well-founded business case and an operating model for realizing value developed before a deal is even announced. Since the early 1980s, the buyer’s stock price has fallen immediately after the deal was announced in two-thirds of all deals. As we show in our m&a study, that drop in most cases is a precursor of even worse results as the company’s subsequent performance confirms the market’s initial negative expectations. The stock market’s routinely negative response to m&a announcements reflects investors’ skepticism that the acquirer will be able to maintain both the original values of the combining businesses and achieve the synergies required to justify the premium. The typical result: The larger the premium, the worse the share price performance. But why is the market so skeptical? Why do acquiring companies have such a difficult time creating value for their shareholders? First is the fact that acquisitions, although a fast route to growth, require full payment up front. By contrast, investments in research and development, capacity expansion, or marketing campaigns are made in stages over time. In acquisitions, the financial clock starts ticking on the entire capital investment from the beginning. Investors want to see compelling evidence that timely performance gains will materialize, particularly when a premium is being paid. Otherwise, a company’s shares will lose value before integration starts. Second, even without paying an acquisition premium, the stock prices of both the acquirer and the target already reflect significant performance improvements. We call this the base case. The capitalized current level of operating performance with no assumed improvement accounts for less than 40% of the typical company’s stock price. The rest of the stock price is based entirely on expected performance improvements. Synergy can occur only when there are operating improvements above the base-case trajectory. Viewed in this light, the typical 30% to 40% acquisition premium for synergy raises the bar even higher – a lot higher – for required improvements, and can be translated into a simple calculation we call shareholder value at risk (SVAR) (see the sidebar, “Shareholder Value at Risk in Acquisitions”). The bottom line, though, is that acquirers can lose a great deal more than the premium by not protecting the profitable growth expectations already built into both their shares and those of the target. Third, synergies don’t come for free. Whether they are revenue synergies or cost synergies, there is almost always a financial cost associated with achieving them. We call this the synergy matching principle. A target cannot be credibly valued without considering the amount and timing of both benefits and related costs. The wrong time to consider severance outlays, additional capital investments, etc., is after a target company has been valued. These unanticipated costs will later translate into shareholder losses. Acquisitions also disappoint when competitors can easily replicate the benefits of the deal. Competitors do not stand idly by while an acquirer attempts to generate synergies at their expense. Arguably, unless an acquisition confers a sustainable competitive advantage, it should not command any premium at all. Indeed, acquisitions sometimes increase a company’s vulnerability to competitive attack because the demands of integration can divert attention away from competitors. Acquisitions also create an opportunity for competitors to poach talent while organizational uncertainty is high. We have seen cases where competitors have held job fairs at local airport hotels and began interviewing key executives at both merging companies immediately following announcement. Finally, it is difficult and extremely expensive to unwind a merger that goes wrong, particularly after significant integration activity takes place. Managers, with their credibility at stake, may compound the problem by throwing good money into bad deals in the fleeting hope that more time and money will prove them right. Duty of care interview guide At the end of the day, the key issue that boards must assess is: How will this deal affect our stock price and why? The time to “stress test” the merger strategy, integration, and communication plans of the senior team is not after the deal is announced. Before approving a deal and recommending it to shareholders, directors must ensure that senior management offers a clear business case and has an operating model in place. The business case should explain why the newly merged organization will beat the performance trajectories already built into both companies’ share prices and how it will offer more of what customers want and cannot get anywhere else, in ways not easily replicated by competitors. An operating model must give direction on how either organization will have to change its leadership, structure, key contractual arrangements, incentives, and so on, so that employees can achieve the objectives of the business case. These issues should be on the board agenda well before the meeting for final approval. In the spirit of the duty of care and what a normal prudent person – or director – in similar circumstances should understand before approving a major acquisition, we offer the following list of straightforward questions that any board can go through with its CEO on a proposed deal. If the CEO cannot answer these questions, then he is clearly not prepared to talk to investors – or the board. Think of this as a final racing diagnostic: * Is there evidence that this deal emerged from a clear strategic process? * How is this deal consistent with the company’s long-term objectives for customers, markets, and products/technologies? * What are the stand-alone expectations of the acquirer and target? * Where will performance gains emerge as a result of the merger? * Are the projected performance gains in line with the premium being paid? * Which competitors are likely to be affected by the deal? * How will those and other competitors likely respond? * What are the milestones in a 12-to-24-month implementation plan? * What additional investments will be required to support the plan? * Who are the key managers responsible for implementing the plan? * Which pieces of either company are good candidates for a sell-off or spin off? * Why is this deal better than alternative investments? Acquisitions, like other business moves, do not happen in a competitive vacuum. In an acquisition drama taking place as this article was being written, AT&T Wireless put itself up for sale after Cingular approached it about an acquisition. Cingular eventually won an auction, bidding $41 billion. The potential combination of the No. 2 and No. 3 carriers in the U.S. wireless industry promises significant scale advantages and will supplant Verizon Wireless as the carrier with the largest U.S. customer base. As the auction process proceeded, Verizon Wireless moved quickly to offer unlimited minutes for customers calling other Verizon Wireless subscribers, thus offering a big competitive challenge because it already has the most wireless customers. Verizon Wireless is essentially acting to capitalize on its size advantage while it lasts and arguably would not have made the promotion had it not been for the threat posed by combining Cingular and AT&T Wireless. Cingular would have had to consider how it would respond to this challenge to have realistically priced the deal. Another often-overlooked consideration is the incremental capital investment that will be required to realize synergies in the combined firm. The 2001 Quaker Oats Co. acquisition by PepsiCo Inc. was largely predicated on distribution and manufacturing synergies but demonstrated how they were realistically valued. For example, Quaker’s Gatorade division could quickly take over production of PepsiCo’s Tropicana “shelf stable” products because of similarity in the manufacturing processes. Large cost savings were promised because Tropicana largely relied on outside contract manufacturers, but the change required investment in incremental manufacturing capacity. Moving those same products into Gatorade’s distribution network also offered significant savings, but again only after incremental investment in additional distribution capacity. Yet, it was clear from PepsiCo’s investor presentation that senior management had considered these required investments before making the offer for Quaker – and also had a plan in place to begin realizing the projected benefits. Given the poor track record of so many major acquisitions and the stakes involved, boards have the responsibility of ensuring that senior management can credibly defend and promote acquisitions that can have a material impact on shareholders. Boards of selling companies that are being offered stock also must get answers to the same questions. Consider the poor MCI Communications shareholders whose board encouraged them to take WorldCom Inc. stock rather than the $34 billion in cash being offered by GTE Corp.! There is a real challenge for boards beyond the procedural requirements of Sarbanes-Oxley. Directors of companies with superior performance records have already stepped up to this challenge of both safeguarding their shareholders’ interests while working with senior management to create value in corporate growth strategies. Taking a cue from Warren Buffett’s opening quote, the board must be able to tell the emperor when he (or his court) is naked. This is why shareholders elect a board of directors. Mark L. Sirower is a Managing Director in the Transaction Services’ Strategy group at PricewaterhouseCoopers in New York where he leads the M&A strategy practice. He is a visiting professor at New York University’s Stern School of Business and author of The Synergy Trap (Free Press). Mark Golovcsenko is a Director in the Transaction Services’ Strategy group at PricewaterhouseCoopers in New York. Reprinted from the March 2004 issue of Mergers & Acquisitions Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com