Managing Risks in Mergers & Acquisitions


By

Surinder Pal Singh
Professor
Rai Business School
A-41, MCIE, Mathura Road, New Delhi-110044
 


A combination of factors - increased global competition, regulatory changes, fast changing technology, need for faster growth and industry excess capacity - have fuelled mergers and acquisitions  in recent times. The M & A phenomenon has been noticeable not only in developed markets like the US, Europe and Japan but also in emerging markets like India. Like capacity expansion, vertical integration  and diversification,  a large merger or  an acquisition is also a strategic move in the sense that it can make or break a company. However, mergers and acquisitions deserve a separate treatment as they involve unique considerations such as the valuation of the company being acquired and integration of the pre-merger entities. Valuation is a subjective matter, involving several assumptions. Integration of the pre-merger entities is a demanding task which has to be managed skillfully.

Mark Sirower, an internationally acclaimed expert in the field of mergers and acquisitions found two thirds of the 168 deals he analyzed between 1979 and 1990 destroyed value for shareholders. When he looked at the shares of 100 large companies that made major acquisitions between 1994 and 1997, Sirower found that the acquirer's stock, on an average trailed the S&P 500 by 8.6%, one year after the deal was announced.  60 of these stocks under performed the market while 32 posted negative returns. Many of the companies acquired were often sold off at a later date and sometimes at a loss. Consider Kimberly Clark's acquisition of Scott Paper. This acquisition made Kimberly-Clark the world's largest tissue maker. One year later however, sales were down, profits & operating income had shrunk and the merged entity was trailing the S&P 500 Stock Index. When AT&T acquired NCR, several hopes were raised. But after five years of losses amounting to more than $2 billion, AT&T accepted that the acquisition would not work and  it decided to spin the company off. Similarly,  the projections made by India's Tata Tea at the time of acquisition of the UK based Tetley did not quite materialised. Quite clearly, mergers and acquisitions involve heavy risks.

Thus, it is commonly seen that in their excitement and enthusiasm to close the deal fast, managers throw caution to the winds. Later, there is a gap between expectations and actual performance and shareholders' wealth is eroded.

Why are mergers risky ?

Major acquisitions have strategic implications because they leave little scope for trial and error and are difficult to reverse. Moreover, the risks involved are much more than financial in scope. A failed merger can disrupt work processes, diminish customer confidence, damage the company's reputation, cause employees to leave and result in poor employee motivation levels. So the old saying, discretion is the better part of valour, is well and truly applicable here. A comprehensive assessment of the various risks involved is a must before striking an M&A deal. Circumstances under which the acquisition may fail including the worst case scenarios should be carefully considered. Even if the probability of a failure is very low but the consequences of the failure are significant, one should think carefully before rushing to complete the deal.

The strategic implications of a merger should be understood carefully. Otherwise, the shareholders' wealth will be eroded. As Mark Sirower puts it neatly: "When you make a bid for the equity of another company, you are issuing cash or claims to the shareholders of that company. If you issue claims or cash in an amount greater than the economic value of the assets you purchase, you have merely transferred value from the shareholders of your firm to the shareholders of the target right from the beginning."

There are two main reasons for the failure of an acquisition. One, there is over enthusiasm about strategic, unquantifiable benefits of the deal which results in over valuation of the acquired company.  Two, wrong integration strategies which result in a gap between possible and actually realised synergies. Many companies are enthusiastic about generating cost savings before the merger, without appreciating the practical difficulties involved in realising them. For example, even if a job is eliminated, the person currently on that job may have to be shifted elsewhere, leaving head count in tact. Many firms enter a merger hoping that efficiency can be improved by transferring best practices and core competencies between the acquiring and acquired companies. Cultural factors may, however, prevent rapid diffusion of such knowledge. The  merger of Daimler Benz and Chrysler is a good example. Another important point to keep in mind is that it may take much longer to generate cost savings than anticipated. The longer it takes to cut costs, the lesser the value of the synergies generated. Revenue growth, the reason given to justify many mergers is in general more difficult to achieve than cost cutting. In fact, growth may be adversely affected after a merger if customer or competitor reactions are adverse. When Lockheed Martin acquired Loral, it lost business from important customers such as McDonnell Douglas, who were Lockheed's competitors. So, companies must look at the acquisition in terms of the impact it makes on competitive forces. The acquisition should be able to put a check on the ability of competitors to retaliate or target the existing markets for the pre merger entities. Some M&A experts look at revenue enhancement as a soft synergy and discount it heavily while calculating synergy value.

Arriving at the premium

One of the most thoughtful treatments of the premium involved in acquisitions is provided by Porter. Porter points out that an efficient market eliminates the possibility of generating more returns than the pre merger entities are generating currently. If the management of the acquired company is sound and the company itself has a bright future, its market price would already have been bid up. On the other hand, if its future is bleak or the management is weak, the stock price could be low but the infusion of capital and effort required to turn it around could also be massive. As Porter puts it: "To the extent that the market for companies is working efficiently, then, the price of an acquisition will eliminate most of the returns for the buyer. The market for companies and the seller's alternative of continuing to operate the business work against reaping above-average profits from acquisitions. Perhaps, this is why acquisitions so often seem not to meet managers' expectations."

While acquiring a company, firms must be careful about irrational bidders with non-profit motives or who are pursuing the deal purely because of the idiosyncrasies of the top management. In the race to the finishing line, companies may end up paying too high a price because of the influence of such bidders. The board should exercise a sobering influence in such situations.

According to Sirower, the acquiring company must consider the following while working out the premium, stand alone market expectations about the acquired company the tangible performance gains from the merger, the management talent necessary to achieve the gains impact on competitors, the possible response milestones in the implementation plan, additional investments which will be necessary, comparison of the acquisition with alternative investments.

Integration

Many mergers fail at the stage of integration. So, it is important to understand carefully the risks involved in integration and how to manage them. All acquisitions must begin with a strategic vision, which serves as a guide for the implementation plans. The vision should be backed by an operating strategy which addresses the issue of how the value chain performance can be improved, whether competitors will react aggressively and if so how they can be dealt with. Vision and operating strategy must be backed by proper systems and processes to align the behavior of managers with corporate objectives. An important point to be noted here is that some operations should be tightly integrated while others should be left alone. What to integrate and what to leave alone is a matter of judgement but there are some useful guidelines to be followed. The  merger of Borroughs and Sperry illustrates some of the challenges involved in integration of the pre merger entities. The two computer makers who came together to form Unisys felt that the merger would generate economies of scale, improve efficiencies and boost price competitiveness. The integration of the distribution system was however a disaster. The companies had different order entry and billing procedures. After the attempted integration, equipment orders were executed late and customers regularly frustrated by missing parts. The stock price of Unisys fell sharply and about 90% of shareholder value was  destroyed.

The acquisition of Republic Airlines by Northwest Airlines also ran into integration problems. The two computer systems could not be synchronised. Integration of crew and gate scheduling and human resources compared to those of Northwest. Low morale led to a deterioration in customer service. After  a Northwest plane crashed after taking off from Detroit, matters ran into serious problems. Personal chemistry, especially at the top matters a lot during integration of the pre merger entities. In general, it is not advisable to have two bosses. Decisive leadership is best provided by a single individual, not by a two man team or a committee. And, if co-CEOs are named after the merger, they will ensure a period of uncertainty during which people wait to see who finally gains the upper hand. In the Citicorp-Travellers Group merger, Sandy Weill of Travellers had taken control, ousting Citicorp's John Reed and in the case of the Daimler Chrysler merger, Jurgen Schrempp gained the ascendancy over Chrysler's Bob Eaton. In both cases, till the clear leader emerged, things were in a state of flux and employees remained confused.

Post merger drift tendencies should be minimised by managing the transition quickly. If decisions and changes are not implemented fast, the acquirer may become focussed on internal issues and lose sight of customers and competitors. Decisions about lay offs, restructuring, reporting relationships, etc must be made within days of the deal being signed and communicated quickly to the employees. However, in an attempt to move fast, people should not be brushed aside. They should be treated with respect and sensitivity. Hearing tends be selective during the early days of a merger, when anxiety levels are high. So, some messages may have to be repeated. Besides internal communication, external stakeholders such as customers, vendors and the community must be kept informed. When a company has decided to pursue a strategy of growth by acquisitions, clearly defined integration plans can be helpful. It should also identify the team which will conduct due diligence and the team which will plan and implement the merger. Checklists must be prepared to indicate the tasks and suggested deadlines. Cisco, which makes acquisitions at regular intervals, uses a standard business process for managing acquisitions.

Stock vs Cash deals

The way the deal is financed determines how risk is shared between the buyer and the seller. In general, there are two types of financial risk faced during an acquisition one, the fall in share price of the acquiring company from the time of announcement of the deal to its closing and two, the possibility of synergies not being realised after the deal is closed. In a cash deal, the acquiring company assumes both the risks completely. In a stock swap where a fixed value of the acquiring company's shares is offered to the acquired company, the first risk remains with the acquiring company but the second risk is shared by the two companies. In a stock swap where a fixed number of shares is offered to the acquired company, both the risks are shared between the two companies.

Various considerations dictate the method of financing the deal. If the acquirer feels its shares are undervalued, a cash deal is preferable as any fresh issue of shares would further erode the wealth of existing shareholders. If the acquirer is very confident about actually realising the projected synergies, a cash deal makes sense. Where such confidence is lacking, a stock deal allows the risk to be atleast partially hedged. In general, a fixed value offer is an indication of greater confidence on the part of the acquirer than a fixed number of shares and tends to be better received by the market. A fixed share offer, ironically enough by minimising the pre closing market risk for the acquirer, acts as a kind of self fulfilling prophecy and drives the share price downwards.

Antitrust issues

An important risk in the case of mergers and acquisitions is anti-trust attention. Whenever a big merger deal is announced, competition authorities view it with suspicion. And, when a company is big and enjoys an overwhelmingly large market share, competition authorities tend to view it through a microscope. This is especially relevant in the case of companies like Microsoft. To get around the problem, a company like Microsoft  has by and large concentrated on acquiring small companies or has taken minority stakes in large companies. Image counts when approval of the competition authorities is involved and a company like Infosys, with a very positive, friendly image will be viewed more positively than Microsoft, which is perceived to be a tough no nonsense competitor.

Concluding Remarks

In this article, we have tried to understand the risks associated with mergers and acquisitions. In their anxiety to close the deal or in their enthusiasm to grow big, companies strike deals of questionable merit. A dispassionate analysis of the potential benefits and pitfalls involved is important before going ahead with a merger or a strategic alliance. Board members have an important role to play here, especially the external directors. CEOs must be thoroughly grilled and asked to explain the benefits of the merger. Once the decision to go ahead with the merger   is announced, the focus shifts to integration. This is a task which is underestimated by most companies. In the final analysis, it is the efficiency with which the integration process is managed that decides whether the projected synergies materialise. The difficulties in planning and executing acquisitions make them very risky. Managers should never forget these risks when they strike deals.
 


Surinder Pal Singh
Professor
Rai Business School
A-41, MCIE, Mathura Road, New Delhi-110044
 

Source: E-mail March 9, 2009

          

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