Ex Ante Market Reactions

Exhibit 7.1 summarizes the results of dozens of academic studies of transactions involving public companies. Shareholders of acquired companies are the big winners, receiving on average a 20 percent premium in a

Exhibit 7.1 Empirical Studies of M&A Activity

Exhibit 7.1 Empirical Studies of M&A Activity

friendly merger and a 35 percent premium in a hostile takeover. Shareholders of acquiring companies, on average, earned small returns that are not even statistically different from zero. The shareholders of acquired companies receive most of the benefit, because competition among acquirers forces the target's price up to the point where little or no expected benefit to acquiring shareholders is left.

This does not mean that acquirers never succeed after the fact nor that the market's reaction to a deal is always lukewarm or unfavorable. However, it does serve to point out how skeptical investors are about the likelihood of acquirers getting more than they pay for in a deal. Likewise, a favorable initial reaction by the market is merely an expectation that the deal will create value—whether it will is revealed over time.

To know that overall the market is unimpressed with acquirers' deals, despite undoubtedly glowing promises when the deals were announced, is certainly interesting and sobering. But it masks additional information about what types of deals the market might expect to create value. To probe this, several colleagues analyzed the market's ex ante reaction to all transactions with a deal size greater than $500 million among publicly traded U.S. companies from January 1996 to September 1998. The results are consistent with prior academic findings—acquirers on average were not expected to earn exceptional profits from their deals, while selling shareholders gained significantly 90 percent of the time.

Peering beneath the surface of the results reveals that there were many transactions the market thought were good deals for the acquiring shareholders. The problem is that there are also many that were expected to be poor deals—leading to an insignificant overall effect. For acquirers whose stock moved significantly one way or the other near the announcement of a deal, 42 percent were winners and 58 percent losers.

What types of deal were expected to be good ones? The research suggests the following factors at work, all of which comport with common sense:

• Bigger value creation overall. An acquirer can increase its chance of success significantly if there is seen to be substantial value creation in the whole deal. If the deal is judged a marginal or losing proposition overall, acquirers' share prices dropped 98 percent of the time. If there is seen to be substantial juice—believable, unique synergies—in a deal, it's much more likely that the acquirer will be able to capture a portion for its shareholders, while paying a ''fair" price to the sellers.

• Lower premiums paid. Acquirers who pay lower premiums (less than 10 percent or no premiums) are three times as likely to see their stock prices affected favorably by the announcement. Moreover, acquirers who buy subsidiaries or divisions of other companies are more likely to have deals seen as favorable than buyers of entire publicly traded companies. This could be due to lack of a publicly traded price to anchor price negotiations, the desire of sellers to complete a transaction so management can rid itself of a problem division, or perhaps the ability of the acquiring company to integrate the business more rapidly and effectively.

• Better-run acquirers. Below-average operators fared less well than acquirers whose financial performance was above average for their industries. Acquirers whose five-year returns on invested capital (ROIC) were above average for their industries were statistically more likely to see their stock price rise upon announcement of a deal—whereas below-average performers were more likely to see their prices drop.

Ex Post Results

So much for the stock market's prognostications—what really happens? In the late 1980s, McKinsey's Corporate Leadership Center studied 116 acquisition programs, usually involving multiple acquisitions in the United States and the United Kingdom, between 1972 and 1983. They started with companies in either the Fortune 200 largest U.S. industrials or the Financial Times top 150 U.K. industrials. A program was judged successful if it earned its cost of capital or better on funds invested in it, after giving the programs at least three years to season. Programs usually involved multiple acquisitions such as General Mills' 47 acquisitions of small, high-growth, consumer-oriented companies. Unfortunately, sixty-one percent of the programs ended in failure, only 23 percent in success. For the 97 programs that were clear winners or losers, the greatest chance of success (at 45 percent) was for those programs where acquirers bought smaller companies in related businesses.1 If

1 The acquired company was judged to be small if the purchase price was less than 10 percent of the acquiring company's market value. It was classified as related if the target's markets were similar to those of the acquiring company.

the target was large and in an unrelated line of business, then the success rate fell to only 14 percent.

Consistent with the ex ante results, the probability of success is also heavily influenced by the strength of the core business of the acquirer. Of the 23 percent of U.S. programs that were successful, 92 percent had high performing core businesses.

In another study, Anslinger and Copeland looked at the results achieved by 13 leveraged buyout firms and 8 U.S. corporate buyers of businesses that seemed not to have synergies with the acquirer.2 Overall, these 21 companies were very successful. They made 829 acquisitions and 80 percent believed they had earned more than the cost of capital invested in their deals. The U.S. corporate acquirers averaged more than 18 percent return to shareholders over a 10-year period, outperforming the S&P 500 during the period. The buyout firms reported that return to investors exceeded 35 percent in the period. The results provide a sharp contrast to those obtained by the typical large corporate buyer described earlier.

How did the buyout firms do it? They focused on quickly improving operating performance at acquired companies. They identified and created big incentives for the top leaders at the companies—and replaced them if their performance did not make the grade. They focused on the cash flow generated by the business, rather than accounting earnings, and used an active and interactive involvement among owners, board members, and management to push the pace of change and create a sense of urgency. Finally, many of the acquirers had their personal wealth involved in each deal. They concentrated on buying at reasonable prices, identifying concrete operating improvements, and extracting their investment within five years. This is quite a contrast to the typical large company, where management has little direct stake in a business it buys and can be easily deluded into accepting "strategic" arguments for paying more.

Overall, the record suggests that profitable growth by acquisition is not easy, although some management teams and buyers have been successful. More often, management finds that its acquisition proposals are met with skepticism and worse by investors and by poor returns afterwards.

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