Baron Philippe de Rothschild, ever an opportunist, is said to have advised, “Buy when there’s blood in the streets.” Investors like Warren Buffett do just that all the time. Hedge funds have been set up specifically to take advantage of carnage in the markets. But for some inexplicable reason, many corporate C.E.O.’s can’t seem to stomach making a big deal when the going gets tough.
The New York Times ran an interesting story (Mergers in a Time of Bears) Tuesday by Andrew Ross Sorkin. The article comments on a recent study, which examined how successful mergers were based on when in the merger cycle they were announced. While the findings of the study are not exactly earth-shattering, they do confirm what many investors have long believed: many mergers that were completed when acquirees were cheap at the beginning of a merger boom have been successful. Some of the best IRRs on investments by private equity firms have been achieved when the PE firm purchased the company in a recession or at the beginning of buyout boom. Buying something cheap when no one else is buying it makes perfect sense; you could earn a larger return than if you bought it at the peak of valuations in a merger boom.
The study, published in this month’s Academy of Management Journal, found that deals struck in the first 15 percent of a consolidation wave tend to do well—at least measured by the acquirers’ share performance against that of the broad market. The value destroying deals come later, when other companies join in the buying spree. The undeniable existence of first mover advantage seems obvious. The study examined 3,194 public companies that purchased other companies during acquisition waves between 1984 and 2004. “Our findings suggest that the market rewards executives who perceive opportunities early, scan the environment for targets and move before others in their industry,” said Mr. McNamara, one of the professors behind the study. “Conversely, the market severely punishes followers, those firms that merely imitate the moves of early participants in the wave, who jump on the acquisition bandwagon largely because of pressures created by competitors. Such companies typically lose significant stock value.” To define a merger wave, the professors looked at 12 industries over the 20-year period. To qualify as a wave, merger activity had to show a pattern in which the peak year had “a greater than 100 percent increase from the first year followed by a decline in acquisition activity of greater than 50 percent from the peak year.” Waves were as long as six years for some industries.
If it is the case that buying early in a merger wave is beneficial, then why don’t we see more of it? Why are CEOs hesitant to be contrarians, and sit back when other CEOs in their industry are not acquisitive? During volatile markets it seems like many CEOs are hesitant to act because of uncertainty in the market. However, by completing a merger when there is uncertainty, CEOs would certainly increase the possibility that their mergers would be successful. It may be counterintuitive to believe that deals consummated in volatile markets will perform better, but this study certainly supports that postulation. However, many CEOs may take this all with a grain of salt since even the quintessentially successful CEO, Jack Welch, didn’t follow the counterintuitive nature of this study’s findings. The study found, however, that serial acquirers like General Electric (NYSE:GE) don’t seem to do well through consolidation waves. Companies that “undertake acquisitions on a regular basis as part of their core business routines” are less likely “to either seize early-mover benefits or suffer from the costs associated with bandwagon pressures.”
The Prince completely agrees that most mergers fail to increase shareholder value. It also makes sense to him that mergers completed when assets are cheaper do have a higher probability of being successful. By this logic, one could suggest that consolidation now in the mining industry will probably result in mergers that destroy shareholder value. Timing is everything in trading, so why shouldn’t this apply in larger mergers? Anyway, here are some interesting excerpts from the article.
Most mergers fail. If that’s not a bona fide fact, plenty of smart people think it is. McKinsey & Company says it’s true. Harvard, too. Booz Allen Hamilton, KPMG, A. T. Kearney — the list goes on. If a deal enriches an acquirer’s shareholders, the statistics say, it is probably an accident.
But a new study puts a twist on the conventional wisdom. It’s not that all deals fail. It’s just that timing appears to be everything. Deals made at the very beginning of a merger cycle regularly succeed. It’s the rest that fall flat.
Notwithstanding Microsoft’s $44.6 billion takeover bid for Yahoo or Electronic Arts’ $2 billion offer for Take-Two Interactive, 2008 is going to be an abysmal year for deal-making. Volume in mergers and acquisitions has plummeted 37 percent this year in the United States, according to Dealogic. (Factor out Microsoft-Yahoo and the drop is a whopping 56 percent.) That’s partly a result of the private equity folks’ being taken out of the equation because of the credit crisis. But it is also because C.E.O.’s and boards become paralyzed when the markets turn turbulent. Instead of making investments, they hunker down and focus on putting their houses in order. Remember those pundits who said corporations would fill the void left by private equity? They were wrong — only they shouldn’t have been.
Take the telecommunications industry. AT&T’s acquisition of Cingular (now AT&T Wireless), which was announced in February 2004, has turned out to be an unqualified winner. But the merger of Sprint and Nextel, unveiled 11 months later, was and is a disaster.
The numbers tell the story. Early movers — companies that made acquisitions in the beginning of a consolidation wave within their industry — found their stock up, on average 4 percent relative to where the shares would ordinarily trade, according to the study. Shares of latecomers, who bought at the end of a wave, fell by an average of 3 percent during that time. Of course, at the end of every wave there are bigger and more deals. After all, stocks are usually up, and so is boardroom confidence (read: exuberance). “There’s a social pressure,” Mr. McNamara said. “They like to be in the herd.”
There are a couple of caveats to the study. The professors measured the acquirers’ stock appreciation or deprecation by using a fancy calculation of what they call “abnormal returns,” which examined share prices five days before the announcement of the acquisition and prices 15 days later. The math is complicated, but they say the “abnormal return” is predictive of stock performance in the future. Of course, critics could argue the study doesn’t measure a long enough period after a deal is made.
Nonetheless, the point is clear: C.E.O.’s should stop being such scaredy-cats. While everyone else is battening down the hatches, go make a deal. The wave is just starting.