The Synergy Trap: How Companies Lose the Acquisition Game - Hardcover

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Mark L. Sirower teaches business strategy and competitive analysis at the Stern School of Business at New York University. He speaks frequently on creating value through mergers and acquisitions for major corporations and in a variety of public forums. The Synergy Trap is based on his pathbreaking Columbia University doctoral thesis. He lives in Manhattan.

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Excerpt

Chapter 1

Introduction: The Acquisition Game

Many managers were apparently over-exposed in impressionable childhood years to the story in which the imprisoned, handsome prince is released from the toad's body by a kiss from the beautiful princess. Consequently they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price they'd pay if they made direct purchases on their own? In other words investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses better pack some real dynamite. We've observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.
Warren Buffett, 1981 Berkshire Hathaway Annual Report

The 1990s will go down in history as the time of the biggest merger and acquisition (M&A) wave of the century. 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. But shareholders of the target firms, who receive a substantial premium for their shares, usually gain.

Here's a puzzle. Why do corporate executives, investment bankers, and consultants so often recommend that acquiring firms pay more for a target company than anybody else in the world is willing to pay? It cannot be because so many acquisitions turn out to be a blessing in disguise. In fact, when asked recently to name just one big merger that has lived up to expectations, Leon Cooperman, the former cochairman of Goldman Sachs's investment policy committee, answered, "I'm sure that there are success stories out there, but at this moment I draw a blank."

It doesn't make sense. For over thirty years, academics and practitioners have been writing books and articles on managing mergers and acquisitions. Corporations have spent billions of dollars on advisory fees. The platitudes are well known. Everyone knows that you should not pay "too much" for an acquisition, that acquisitions should make "strategic sense," and that corporate cultures need to be "managed carefully." But do these nostrums have any practical value?

Consider. You know you've paid too much only if the acquisition fails. Then, by definition, you have overpaid.

But how do we predict up front whether a company is overpaying for an acquisition - in order to prevent costly failures? What exactly does the acquisition premium represent, and when is it too big? What is the acquirer paying for? These are the details, and the devil is in them.

This book returns to first principles and precisely describes the basics of what I call the acquisition game. Losing the game is almost guaranteed when acquirers do not realize that acquisitions are a special type of business gamble.

Like a major R&D project or plant expansion, acquisitions are a capital budgeting decision. Stripped to the essentials, an acquisition is a purchase of assets and technologies. But acquirers often pay a premium over the stand-alone market value of these assets and technologies. They pay the premium for something called synergy.

Dreams of synergy lead to lofty acquisition premiums. Yet virtually no attention has been paid to how these acquisition premiums affect performance. Perhaps this is because the concept of synergy itself has been poorly defined.

The common definition of synergy is 2 + 2 = 5. This book will show just how dangerous that definition is. Pay attention to the math. The easiest way to lose the acquisition game is by failing to define synergy in terms of real, measurable improvements in competitive advantage.

A quantifiable post-merger challenge is embedded in the price of each acquisition. Using the acquisition premium, we can calculate what the required synergies must be. Often this calculation shows that the required performance improvements are far greater than what any business in a competitive industry can reasonably expect.

By analyzing the acquisition premium, we can determine in advance when the price is far above the potential value of an acquisition. We can also show why most purported synergies are like the colorful petals of the Venus flytrap - dangerous deceivers. But managers who analyze the acquisition premium and understand the concept of synergy will not get caught. They can predict the probability and the amount of shareholder losses or gains.

My claim is that most major acquisitions are predictably dead on arrival - no matter how well they are "managed" after the deal is done.

The M&A Phenomenon

Mergers and acquisitions are arguably the most popular and influential form of discretionary business investment. On the single day of April 22, 1996, with the announcement of the Bell Atlantic - NYNEX merger and Cisco Systems' acquisition of Stratacom, over $27 billion of acquisitions were announced. For 1995, the total value of acquisition activity was over $400 billion. By comparison, in the aggregate managers spent only $500 billion, on average, over the past several years on new plant and equipment purchases and a mere $130 billion on R&D.

Acquisition premiums can exceed 100 percent of the market value of target firms. Evidence for acquisitions between 1993 and 1995 shows that shareholders of acquiring firms lose an average of 10 percent of their investment on announcement. And over time, perhaps waiting for synergies, they lose even more. A major McKinsey & Company study found that 61 percent of acquisition programs were failures because the acquisition strategies did not earn a sufficient return (cost of capital) on the funds invested. Under the circumstances, it should be natural to question whether it is economically productive to pay premiums at all.

Logically, we should expect that managers choose an acquisition strategy only when it offers a better payoff than other strategic alternatives. But there are several pitfalls inherent in acquisitions because they are, in fact, a very unique investment.

First, since acquirers pay a premium for the business, they actually have two business problems to solve: (1) to meet the performance targets the market already expects, and (2) to meet the even higher targets implied by the acquisition premium. This situation is analogous to emerging technology investments where investors pay for breakthroughs that have not yet occurred, knowing that competitors are chasing the same breakthroughs. However, in acquisitions, the breakthroughs are called "synergies."

I define synergy as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently. In other words, managers who pay acquisition premiums commit themselves to delivering more than the market already expects from current strategic plans. The premium represents the value of the additional performance requirements.

Second, major acquisitions, unlike major R&D projects, allow no test runs, no trial and error, and, other than divesting, no way to stop funding during the project. Acquirers must pay up front just for the right to "touch the wheel."

Finally, once companies begin intensive integration, the costs of exiting a failing acquisition strategy can become very high. The integration of sales...