Shareholders Value At-Risk Acquisitions (Honing Supp)

The purchase price of an acquisition often is driven by the pricing of other “comparable” acquisitions rather than by a rigorous assessment of where, when, and how management can drive real performance gains. A simple tool we’ve found useful with acquirer boards for assessing the relative magnitude of synergy risk is a straightforward calculation we call shareholder value at risk (SVAR). SVAR is simply the premium paid for the acquisition divided by the market value of the acquiring company before the announcement is made. Think of it as a “bet your company” index, which shows how much of your company’s value is at risk if no post-acquisition synergies are realized. This index also can be calculated as the premium percentage multiplied by the market value of the seller relative to the buyer. The greater the premium percentage paid to sellers and the greater their market value relative to the acquiring company, the higher the SVAR. Of course, as we’ve discussed, it’s possible for acquirers to lose even more than their premium. In these cases, SVAR underestimates risk and is, therefore, a conservative measure of risk. Figure 3 shows how an acquirer’s SVAR for an all-cash deal varies both with the relative size of the acquisition and the percentage premium paid. The Figure also shows how SVAR for an acquirer is different for a stock deal. Why would this be different? The main distinction between cash and stock transactions is this: In cash transactions, acquiring shareholders take on the entire risk that the expected synergy value embedded in the acquisition premium will not materialize. In stock transactions, that risk is shared with selling shareholders. More precisely, in stock transactions, the synergy risk is shared in proportion to the percentage of the combined company the acquiring and selling shareholders each will own. To calculate an acquirer’s SVAR for a fixed-exchange ratio stock deal, multiply the all-cash SVAR by the percentage that the acquirer will own in the combined company. We assume for the all-stock example in Figure 3 that the acquirer shareholders will own 75% of the combined company and the selling shareholders will own 25% of the combined company. Little wonder then why acquirers found shares such an attractive method of payment in the recent merger boom. But there is a big catch: Investors are smart. While, technically, SVAR is reduced, stock deals send two important signals to investors. First, the best time to issue new shares is when they are overvalued. Thus, there is a classic asymmetric information problem where the seller must question the motives of the buyer. Second, if an acquirer’s management team was truly confident about getting the projected synergies, why would it want to share the future benefits by paying with stock? In other words, paying with stock is a signal of lower confidence in the deal than if the acquirer paid with cash. Moreover, cash deals typically require debt financing that requires both confidence and discipline to meet the interest payments. When acquirers pay with stock they often lull themselves into acting as though somehow equity is free and forget about its required return (the cost of capital). Ironically, the same CEOs who publicly declare their company’s share price to be too low will cheerfully issue large amounts of stock at that “too low” price to pay for their acquisitions. As we show in our study, investors regularly express their rightful suspicion when CEOs are careless with offers of stock. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com