The merger wave of the 1980s has become the tidal wave of the 1990s. With more than $750 billion in acquisition announcements in 1997, acquisitions have clearly become this generation of executives’ favorite corporate growth strategy. 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. After decades of research and billions of dollars paid in advisory fees, why do these major decisions continue to destroy value for the shareholders of acquiring companies? The objective of any writing on this subject must be to aid decisionmakers who must choose between strategic investment alternatives in their quest for creating shareholder value. By their nature, acquisition decisions require far more up-front financial and strategic analysis than what normally occurs before the corporate checkbook is opened. Paying substantial takeover premiums for already existing assets and technologies in the name of corporate growth is now commonplace. If an acquirer is willing to pay more for another company than anyone else in the world is willing to pay, without clear plans for performance gains, it should not be a surprise when the market value of the company drops by the amount of the premium or more. Acquisitions carry huge up-front risk because all the money is paid up front before the acquirer can get behind the wheel. This is why so many acquisitions that ultimately fail are predictably DOA no matter how they are managed after the deal is done. For example, when NationsBank announced its acquisition of Barnett Banks at a $2.5 billion premium in stock, NationsBank’s shareholders promptly lost nearly $2.5 billion. Is it just a coincidence? And within six weeks of announcement of the largest acquisition in history, WorldCom had lost over $6.3 billion of it own market value nearly 41% of the $15.5 billion premium WorldCom agreed to pay for MCI. Hope often springs eternal in mergers and acquisitions. Some observers of m&a activity have commented that “the stock price of the acquirer always goes down on the announcement of an acquisition,” so these shareholder losses have little meaning. This statement is simply not true. Consider Gillette’s acquisition of Duracell and Procter & Gamble’s acquisition of Tambrands. In both of these recent acquisitions, the shareholders of both Gillette and P&G gained more than $2 billion dollars of value right on announcement of the acquisitions. Officers and directors owe a duty of care and a duty of loyalty to their corporations and their shareholders. The business judgment rule protects those officers and directors where their decisions are prudent and informed. Although it is not unusual for a company’s stock price to fall on the announcement of disappointing earnings, it should more than raise eyebrows when the stock drops significantly on the announcement of a major discretionary corporate investment decision. For the 30% of acquisitions that create value for shareholders, expected synergies are more than just wishful thinking. And these successful acquiring companies have the capabilities to translate their plans into actions. At the end of the day, acquisition decisions involve judgments about the future but these must be informed judgments these are the rules of the game. Acquiring firms routinely destroy shareholder value. This is a plain fact. So the size and scope of acquisition activity should be extremely troubling. But here is another puzzle. Lawsuits and bad press punish other value-destroying corporate decisions. When Metallgesellschaft, Barings Bank, and Procter & Gamble lost millions on derivatives transactions, there was a public outcry about the dangers of these decisions and concern about whether senior management understood enough about the strategies to effectively control them. But acquirers have lost with impunity even billions of dollars of shareholder value as they have pursued poorly understood acquisition strategies. “It seemed like a good strategic decision,” or “It seemed like a good deal at the time,” or “The financials looked good but we just didn’t implement it correctly,” or “We didn’t manage the cultures right.” Should we just laugh when hearing these rationalizations? What is synergy, anyway? Can it be achieved? Or is it just a trap? How can an acquirer know whether any value will be gained from an acquisition, even at a zero premium? These are the questions that must be answered. Warren Hellman, former head of Lehman Brothers, has commented, “So many mergers fail to deliver what they promise that there should be a presumption of failure. The burden of proof should be on showing that anything really good is likely to come out of one.” The objective here is to describe the intensity of this managerial challenge. If Value (NPV) = Synergy – Premium, then the first step in understanding synergy is to consider what an acquisition must accomplish to generate value at a zero premium. It is hard to achieve synergy even when the acquirer gets the target company at the going market price. Unless certain necessary competitive conditions can be met and the required organizational cornerstones of synergy are in place, there is no chance of performance gains. The synergy trap opens for the eight out of 10 companies involved in major acquisitions that do little preacquisition planning. But even for the two out of 10 that do plan, performance improvements already required by the preacquisition price of both the acquirer and target firms and the certainty of competitor reactions will limit synergies. Like any other major investment decision, acquisitions represent strategic resource commitments. They must be judged by the same standards as any strategic alternative: Does this commitment of resources, both financial and human, create value for the shareholders of the corporation? The shareholders of the acquirer, after all, can buy the shares of the target firm if they want to, on the market, without paying a premium. So why should executives spend shareholders’ money to buy what shareholders can buy more cheaply without help? If the answer to this question is synergy, then we have to understand precisely what synergy means. Synergy and the Acquisition Game When executives play the acquisition game, they pay, in addition to the current market price, an up-front premium for an uncertain stream of payoffs sometime in the future. Since shareholders do not have to pay a premium to buy the shares of the target on their own, these payoffs, the synergies, must represent something that shareholders cannot get on their own. They must mean improvements in performance greater than those already expected by the markets. If these synergies are not achieved, the acquisition premium is merely a gift from the shareholders of the acquirer to the shareholders of the target company. To visualize what synergy is and exactly what the acquisition 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. Current share prices at various market multiples already have substantial projected improvements in profitability and growth built into them. Hence, our operational definition of synergy is this: Synergy is the increase in performance of the combined firm over what the two firms are already expected or required to accomplish as independent firms. Where acquirers can achieve the performance that is already expected from the target, the net present value (NPV) of an acquisition strategy then is clearly represented by the following formula: NPV = Synergy – Premium In management terms, synergy means competing better than anyone ever expected. It means gains in competitive advantage over and above what firms already need to survive in their competitive markets. One reason that synergy is difficult to achieve is that the current strategic plans and resources of the target do have value. The easiest trap to fall into occurs when acquirers forget about this value. Acquirer management must maintain and manage this value while making changes in operations. It may be unrealistic to hope to gain two customers, but it is very easy to lose two customers after an acquisition. As Unisys (the merger of Burroughs and Sperry), Novell (with its acquisition of WordPerfect), and so many other acquirers have learned the hard way, all the cultural management in the world will not generate synergies and will not save an acquisition that reduces the competitiveness of the underlying business. Most of the problems that have been considered in managing acquisitions are important with regard to maintaining value rather than creating it. But acquisitions at a premium demand ever more. Recall that acquisitions are a unique investment decision for some important managerial reasons: * There are no dry runs, and all the money (including the premium) is paid up front; * The exit costs following integration can be extremely high, in both reputation and dollars; and * Managing synergy is in many ways like managing a new venture or a new business. Putting the idea of managing above what is already expected into an earnings per share (EPS) context, we can think of the management challenge of synergy in this way: EPS (tomorrow) = EPS (today) + EPS (today) x Expected Growth + Synergy The management challenge of any business is the base business today plus the expected growth of the future business. The expected future growth and profitability improvements are already embedded in current share prices. Adding synergy means creating value that not only does not yet exist but is not yet expected. So achieving synergy improvements above what is already expected or required is like starting a new business venture. There might be improvements in performance following an acquisition, but if they were already expected, that is not synergy. And if it costs a lot more to run this new venture after the acquisition, funds may be diverted from preacquisition strategic plans, and value may be destroyed rather than created. Let us carefully examine the management challenge already embedded in the preacquisition market value of a firm’s securities. Before an acquirer can even consider paying a premium, it must understand what is already expected to result from current strategies. This is the base case. Performance Requirements Of Preacquisition Market Values The examples presented here are the estimated performance expectations for 1995-2004 given the 1994 performance and year-end total market values for Lotus Development, Scott Paper, Wal-Mart, and Microsoft. The lesson from this analysis is not only the intense management challenge already embedded in the market values of these companies but also the very different types of management challenges. Contrary to the common folklore that Wall Street values only short-term performance, market values do reflect long-term expectations of the performance of firms. The market value of a company (debt plus equity) is equal to the invested capital plus the net present value of this invested capital: Market Value = Invested Capital + NPV of Investments. A company resembles a bond. A bond trades at par if the coupon rate is equal to the discount rate; it trades at a premium when the coupon rate is higher than the discount rate. Similarly, if the market value of a company is greater than its invested capital, it reflects the expectations of investors around the world that current and future invested capital has a positive NPV that is, the return on invested capital is higher than the weighted average cost of capital for the company. This is the basis for estimating the future expectations of performance embedded in the current market value of a company. Given a current market value, current performance, and the amount of invested capital, what must future performance be in order to justify the current value? Figure 1 shows the expected net operating profit (NOP), return on invested capital (ROIC), and the expected spread between the ROIC and weighted average cost of capital (WACC) of each company. This figure presents four different management challenges given the 1994 performance and year-end market values of the four companies. Lotus and Scott Paper, the targets of two recent acquisitions (IBM and Kimberly-Clark, respectively), are earning negative spreads relative to their costs of capital, but their ROIC is expected to improve dramatically over the coming 10 years. Synergies in these acquisitions must be additional performance improvements beyond the already steep expectations. It is not surprising, then, that Wayne Sanders, CEO of Kimberly-Clark, paid a zero premium for Scott Paper, and there were no other bidders. As for IBM’s acquisition of Lotus, the market value of IBM dropped by almost the amount of the premium ($1.65 billion) it paid for Lotus right on announcement of the acquisition (NPV = Synergy – Premium). Contrast this to the performance expectations and challenges for Wal-Mart and Microsoft. For Wal-Mart CEO David Glass, the challenge is maintaining the spreads between ROIC and WACC on a huge amount of invested capital. At year-end 1992, Wal-Mart’s market value was almost $20 billion more than at year-end 1994. In other words, the market had expected much higher spreads. When performance did not meet expectations, the market lowered its expectations about the future performance of Wal-Mart. The picture for Microsoft is truly striking. It illustrates the real dominance that Microsoft has over its competitors. Not only is the company expected to maintain the current spread between its return on capital and its cost of capital of over 15% but this incredible spread is expected to increase. This is how markets work: They anticipate the future. Synergies exist and add value only if they exceed what is already embedded in market prices. Executives must understand the severity of this management challenge before entering the acquisition game especially if they are willing to pay a premium. If they do not understand this picture, as often they do not, then planning for synergy either before or after an acquisition will likely be meaningless. The unfortunate result is an acquisition that is predictably DOA. So where is the new value going to come from? If cultures are managed correctly and all employees receive hats with the new corporate name and logo, will that create synergy? If two large companies are put together that are already operating well above minimum efficient scale and already have to run hard just to stay in place, will cost savings be generated? And if there are cost savings, how much will they be? The synergy problem must be tackled within a competitive context. At the end of the day, acquirers need to be able to show where additional cash will be available to suppliers of capital. How exactly will they generate higher revenues or lower costs less additional required capital investment in a competitive market? The Competitive Challenge of Synergy Certain competitive conditions must be present before synergy can occur in any acquisition, but these necessary conditions are by no means sufficient for performance gains. Recently popular concepts, such as the resource-based view and the core competency view of competitiveness, are really mere descriptions of what has occurred in the past. They give managers little help in formulating expectations about the outcomes of future strategic investments. In these popular views, success derives from private or tacit information and ex post, non-tradable, and specialized resources. Notably lacking is the “how much” quality, so essential for differentiating strategic alternatives. In acquisitions, managers must show what will be different before they can actually value the strategy and begin negotiations on price. They must be prepared to answer how and in what ways it will be more difficult for competitors to compete in the businesses of both the target and the acquirer. They must consider whether competitors will be able to challenge successfully or what I call “contest” the improvements that the acquirer will attempt in order to generate performance gains. Whether merging firms have valuable resources or competencies as stand-alones reveals little about the ability to create synergy. By contrast, the contestability approach that I present here puts the questions that acquirers must ask in competitive terms. Using the value chain concept advanced by Michael Porter of the Harvard Business School, we can think of a business as consisting of input markets, processes, and output markets. In any competitive business, competitors are already attempting to contest each other’s markets by finding the most efficient means of producing a given set of products and services and/or offering a more attractive set of products and services at a given cost structure. In a competitive environment, the only way to earn economic returns is by preventing rivals (current and potential) from winning along the value chain. At least one of the following conditions is necessary: 1. Acquirers must be able to further limit competitors’ ability to contest their or the targets’ current input markets, processes, or output markets, and/or 2. Acquirers must be able to open new markets and/or encroach on their competitors’ markets where these competitors cannot respond. This is the starting point. Condition 1 involves the ability of the acquirer to sustain advantages or decease vulnerabilities. Condition 2 involves the ability of the acquirer to engage competitors in current or new markets in ways that were not previously possible. The following examples illustrate these conditions. Anheuser-Busch/Campbell Taggart/Eagle Snacks Anheuser-Busch (A-B) is a distribution and marketing giant. In 1979, A-B started Eagle Snacks, and in 1982, A-B paid $560 million (about a 20% premium) for Campbell Taggart, a major manufacturer of bread and snacks. What could be more natural than combining the distribution and sales of beer, bread, and salty snacks? After all, they all use yeast. In fact, however, beer and snacks go into different areas of supermarkets and convenience stores, and they have different ordering schedules. Although A-B devised a distribution strategy using Eagle distributors, Campbell Taggart distributors, and its regular beer distributors, it failed to achieve synergy. What’s more, A-B’s beer distributors refused to detract from their own core business to support A-B’s emerging and inevitable fight with snack-food leader Frito-Lay. A-B’s distributors laid the blame for the failure squarely at the feet of Frito-Lay, which did not sit still to watch while A-B generated synergies at its expense. Indeed, as A-B expanded the Eagle product line, Frito-Lay attacked with an array of new products and price cuts on existing products. A-B’s snack market share never topped 6% while Frito’s increased from 40% to 50%. For 1995 alone, the Eagle brand lost $25 million on sales of $400 million. After 17 years of losses, A-B put the Eagle brand to rest. Interestingly, A-B sold its four Eagle Snacks plants to none other than Frito-Lay, and Campbell Taggart was spun off to shareholders. The lesson is that if the strategic moves of an acquirer are easily contestable, competitive gains, and thus synergy, will not occur. Engines for the Boeing 777 The ferocious competition among the potential engine suppliers for the Boeing 777 General Electric, Pratt & Whitney, and Rolls Royce is an excellent lesson in this concept of contestability even though no acquisitions are involved. In 1994, it was expected that supplying the 777 engines would be highly profitable (as the aircraft engine business has been traditionally) and that Pratt & Whitney and General Electric would hold the number 1 and number 2 positions in the business, respectively. At that time, Pratt had more than half of all orders, and it appeared that Rolls-Royce would be a distant third. But Rolls-Royce came in with rock-bottom pricing more than 50% below list prices and seized the number 2 spot while threatening Pratt & Whitney by winning a major Singapore Airlines bid. The ability to contest product markets must be driven by changes in competitiveness in preceding parts of the value chain of the businesses. Just to stay in the game, these aircraft manufacturers have had to slash costs by cutting work force size, closing manufacturing and office space, subcontracting, and moving subassembly to cheaper locations. Rolls reportedly is attempting to cut costs an additional 40%. Lockheed Martin/Loral Corp. Vertical integration acquisitions present other interesting competitor reactions. Lockheed Martin paid $9.l billion for most of electronics supplier Loral Corp. The result is that Loral, as a captive supplier of Lockheed, is now perceived and treated as a competitor by its erstwhile customers. In a move that surprised Loral’s chairman, Bernard Schwartz (now a vice chairman of Lockheed Martin), Harry Stonecipher, CEO of McDonnell Douglas, announced that McDonnell Douglas would switch its business away from Loral to other potential suppliers of electronic systems, such as Litton Industries or Raytheon. Clearly, McDonnell Douglas has little incentive to support the operations of a major rival for defense contracts when there are alternative suppliers. So before Lockheed Martin can realize any net synergies from the Loral acquisition, it will need to make up for the substantial lost business resulting from McDonnell Douglas’s decision to switch suppliers. A similar scenario may play out in the entertainment business, where former suppliers are now owned by competitors. Such relationships may cause serious problems for Viacom, Disney, Time Warner, and others. Achieving synergy is a brand-new competitive problem for executive teams of acquirers, and their competitors will be watching and reacting in anticipation of changes. Acquirers need to ask which of their competitors will stand by silently while the attempt is made to generate synergy at their expense. In hypercompetitive environments, this expectation is simply unrealistic. Unfortunately for acquirers, these contestability con-ditions are necessary but not sufficient. For example, customers may not value the new products or may not want to change their buying habits. The acquisition may require substantial additional investments in the business, even beyond the target’s price, that negate any additional operating profitability. If the executives of an acquirer do not understand the target’s businesses well enough to consider these issues, they will be extremely hard-pressed to develop a credible outlook for potential performance gains.