Rules Of The Acquisition Game

Acquisitions require tremendous discipline. That is, the courage to walk away from an acquisition opportunity that is attractive in every way except price. Over the years we have made that walk many times. Robert Cizik, Chairman and CEO, Cooper Industries (1995).

Officers and directors owe a duty of care and a duty of loyalty to their corporations and their shareholders. The business judgement rule protects those officers and directors where their decisions are informed decisions. The long-overdue integration of strategy and finance that this book represents introduces a standard by which to evaluate what constitutes an informed acquisition decision.

Most companies make few, if any, major acquisitions. Because these are exciting but rare events, they easily fall into a category called, "Wow! Grab it!" type of decisions. The elation and 'raring-to-go' feeling that are associated with a decision that will dramatically change the size and shape of a company overnight is undeniable. In crucial decisions, Irving Janis describes the "Wow! Grab it!" decision rule as: "This is better than you could hope for, so grab it; don't take any chance of losing the wonderful opportunity by wast in time looking into it any further."

 

Major acquisitions require deeper analysis than that. In part of this book, I have shown managers why they need to look before they leap. In the next part, I present a comprehensive empirical study of acquiring firm performance that quantifies the risks of these decisions. The evidence surrounding the losses to acquirers cannot be ignored. Other corporate decisions causing only a fraction of these losses bring a public outcry. Losing millions, even billions, of dollars of market value on the announcement of a major resource allocation decision means something is wrong. Markets have seen the acquisition game played too many time before. Most companies contemplating a major acquisition have not.

I have presented acquisitions a unique business gamble. With the fundamentals developed here, we can predict the fate of most acquisitions, no matter how "strategic" they appear to be. We can make reasonable predictions of how much value will be merely transferred from the shareholders of the acquirer to the shareholders of the company being acquired. In Part 2 of this book, such predictions are tested across twenty-eight measures of shareholder performance spanning different periods of time. I found that losses can be predicted, and the higher the premium, the larger the losses.

Once again, the value to the shareholders of an acquirer is the et present value of the decision:

NPV = Synergy - Premium.

The assertion might be evident, but it is the necessary starting point. It yields what I have called the acquisition game: an up-front premium is paid for some uncertain stream or benefits or payoffs sometime in the future. Managers need to consider the likelihood of different scenarios of these payoffs (synergy), or they will actually know more about the payoffs in blackjack than for an acquisition.

Before a likely amount of synergy can be determined, we have to consider carefully what exactly synergy is and what competitive conditions must be met before anything good is likely to occur. The premium is the amount that acquirer shareholders would not have to pay to buy the shares of the target company on their own, so synergy must be increases in performance above some base case.

Existing stock market prices are formed on the expectations of the future. It is these pre-existing performance expectations that create the base case. Synergy, then, must be performance gains above those that are already expected. This forms the competitive challenge. Synergy must imply gains in competitive advantage that is, competing better than was previously expected. Unless synergy is considered in this context, the trap begins to open, and planning and valuation have little meaning.

Just putting two companies together that appear to be similar or complementary in some way will yield nothing unless the marriage can pass at least one of the contestability conditions:

lAcquirers must be able to further limit competitors' ability to contest their or the target's current input markets, processes, or output markets above what is already expected, and/or

lAcquirers must be able to open new market and/or enroach on their competitors' markets where these competitors cannot respond.

Four organisational cornerstones must be in place for synergy to be anything but a trap:

(1) strategic vision, (2) operating strategy, (3) systems integration, and (4) power and culture. These cornerstones must be set from the beginning. Post-acquisition is the wrong time to begin working out 'the details' because competitors will not sit still while the acquirer attempts to generate synergies at their expense. Moreover, without the details, how could an acquirer ever conduct a valuation of improvements or negotiate on price?

Even when the cornerstones are in place, the acquisition premium dictates massive required performance improvements (RPIs) that in most cases quickly dwarf the amount of performance that could reasonably be achieved. Making matters even worse from a planning basis, the RPIs are dynamic. If delays in synergy are expected, the RPIs get bigger much bigger and markets and competitors know this.

In most acquisitions, the premium does not represent potential value. Illustrated this concept with the acquisition synergy scenarios at the end of Chapter 2. These elements of the acquisition game show how synergy can be measured, how difficult the management problem truly is, and, finally, why the amount of overpayment is predictable.

So the acquisition game is akin to running 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 if 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.

Utilising the preceding principles, we can identify three main sources of tension that arise in the management of an acquisition strategy:

(1) prior expectations and additional resource requirements, (2) competitors, and (3) time, value, and the premium. These issues create difficult and even paradoxical problems for managers.

Prior Expectations and Additional Resource Requirements:

The stock market price of the target company before the acquisition will in most cases have substantial expected improvements already built in. What might appear to be post-acquisition performance gains may have nothing to do with synergy. Additional costs or investments such as increased R&D, new executives, golden parachutes, new plants, or increased advertising can negate any additional benefits in addition to damaging prior expectations. Finally, acquisitions can divert important managerial resources away from the acquirer's other businesses.

The lesson: pay close attention to what is required to maintain value in the stand-alone businesses. This is the base case. When acquirers make organisational or strategic changes to gain the value they paid for in the premium, they run the risk of destroying the growth or value that was already priced by the markets. Additional investments in the businesses are like additions to the premium and must be considered as such if maintaining value is the objective.

Competitors

If proposed changes in strategy or cost-cutting measures are easily contestable by competitors, there will be no synergies. The result is that acquirers will in all likelihood need to make major additional commitments if the changes have a chance of improving competitive advantage. On the other hand, acquirers must question whether integration moves will cause inflexibility, such that the moves of their competitors become difficult to contest. For example, workforce cuts might help efficiency but slow competitive response in the next round of competition. Finally, the longer the acquirer delays in implementing a post-acquisition strategy, the more time competitors have to learn what an acquirer is attempting to do. They will find ways to challenge the acquirer's anticipated moves before 'improvements' even begin.

The lesson: synergies will be the result of competitive gains and must be viewed in this context. An acquisition strategy will not create synergy with only a vision of why it might be a good thing to do. Unless acquirers carefully consider the other three cornerstones of synergy, the additional resources that will be needed to put them in place, and where these changes will improve performance along the value chain, synergy is a trap. The transition to the post-acquisition integration phase must be done quickly and decisively. Otherwise transition management becomes a resource drain and can make the acquirer even more vulnerable to competitors.

Time, Value, and the Premium

The premium translates into required performance improvements that only grow with time, so improvements need to begin immediately. But many improvements can come only from changes that take significant time to plan and implement (distribution, product development, new plant locations, executive succession), and rushing them may prove to be a disaster.

The lesson: do not value the proposed acquisition in one shot. The market has already valued expected future performance of the target company as a stand-alone. The premium must represent improvements above this. Thus, acquirers need to value the improvements when they are reasonably expected to occur. There is no credible way to enter negotiations on price if these issues are not clearly considered. It is difficult to do, but without doing it, the premium is predictor of how much value will be destroyed. Losses can be 'locked in' right up-front even where substantial improvements are made down the road. Finally, missing performance targets that were probably unachievable in the first place is no signal to raise the stakes.

The Synergy Trap Mark L.Sirower Price: $ 18.75 Pages: 289 Published by Free Press Distributed by IBD, Mumbai.

Most companies make few, if any, major acquisitions. Because these are exciting but rare events, they easily fall into a category called, "Wow! Grab it!" type of decisions.