Mergers and acquisitions. Part II
What is a successful M&A deal?
DECEMBER / 2023
An M&A deal involves a number of parties, each has an army of individuals to support it - the target, the acquirer and the bankers to name but a few, and own motives for undertaking a deal. The acquirer has its own motivations. These might start from maximizing shareholder value, capital market efficiency, restructuring to adapt to new economic realities, reaction to external (Ching, 2018) right through to CEO’s personal ego and wanting to be part of the herd in the later stages of an M&A wave (Clark, 2013). The target is driven by some of the same ideals but underpinned by the will to survive rather than flourish. The banker is driven by the commission he receives, traditionally based almost solely on deal closing regardless of what happens next. Hence, measurement of success of an M&A deal might be different for various parties involved and also dependent on the initial M&A strategy.
Measuring success
Renneboog and Vansteenkiste. (2019) state that success of a deal is usually measured as an increase in shareholder wealth for the acquirer, target and/or combined entity in the form of cumulative abnormal returns to shareholders. However, the M&A effect is difficult to disaggregate from other operational factors. In a world of blurred industry lines, it is even less possible to allocate synergies to any particular event such as a merger/acquisition. There is also the complication of calculating the cumulative abnormal returns.
Another measure of success is operational performance such as revenue growth, increasing margins, increase in return on assets, increase in operating cash flows etc. as these directly relate to the concept of synergies and are fairly easy to measure using accounting instruments. Although an accounting measure is easy to use and interpret, it is also easily manipulated to present the outcome favourable to the shareholders because it ultimately relies on the accounting standards used and their interpretation by management. Using accounting measures in general is also dependent on the specific accounting measure used. For example, EBITDA can provide a different outcome to return on assets employed and to operating cash flows of a combined entity. There are also considerations of comparison as a stand-alone measure is not a sufficient indicator as it must be compared to a benchmark such as industry average at a point in time or across time to other similar type of deals by the same acquirer.
Maksimovich, V., Phillips, G. and Prabhala, N.R. (2011) explore success of a deal from the point of view of productivity. After the deal is closed many acquirers restructure operations by selling their own and the target’s assets. Those operations that are retained after three years show an increase in productivity and those which are disposed of do not which can indicate that the M&A deal has led to optimization of asset portfolio in the combined company and an increase in overall efficiency which can be a suitable measure of success.
This approach to performance is also reflected in Ching’s work on reasons for undertaking an M&A deal, discussing the industry shock theory, where a policy, regulatory or another shock leads to a change in asset values which in turn leads to transfer of assets between companies driving M&A activity, and Q-theory based on investment valuation approaches where well managed overvalued companies buy undervalued companies as it is good investment, once again reallocating assets in the process.
Defining success of an M&A deal and measuring it is still an open question for many scholars and market participants. There are many dimensions to it including short-term and long-term considerations, measures, benchmarking. Critical success factors of an M&A deal can be broken into internal and external factors. Internal factors are effective integration, accurate target valuation, adequate due-diligence, cultural alignment and sufficient talent at the target, and the external factors are economic certainty, regulatory stability and favourable market forces. Ultimately, it is a decision to be made by those involved in the deal as to how the outcome will be defined and measured.
Renneboog and Vansteenkiste. (2019) state that success of a deal is usually measured as an increase in shareholder wealth for the acquirer, target and/or combined entity in the form of cumulative abnormal returns to shareholders. However, the M&A effect is difficult to disaggregate from other operational factors. In a world of blurred industry lines, it is even less possible to allocate synergies to any particular event such as a merger/acquisition. There is also the complication of calculating the cumulative abnormal returns.
Another measure of success is operational performance such as revenue growth, increasing margins, increase in return on assets, increase in operating cash flows etc. as these directly relate to the concept of synergies and are fairly easy to measure using accounting instruments. Although an accounting measure is easy to use and interpret, it is also easily manipulated to present the outcome favourable to the shareholders because it ultimately relies on the accounting standards used and their interpretation by management. Using accounting measures in general is also dependent on the specific accounting measure used. For example, EBITDA can provide a different outcome to return on assets employed and to operating cash flows of a combined entity. There are also considerations of comparison as a stand-alone measure is not a sufficient indicator as it must be compared to a benchmark such as industry average at a point in time or across time to other similar type of deals by the same acquirer.
Maksimovich, V., Phillips, G. and Prabhala, N.R. (2011) explore success of a deal from the point of view of productivity. After the deal is closed many acquirers restructure operations by selling their own and the target’s assets. Those operations that are retained after three years show an increase in productivity and those which are disposed of do not which can indicate that the M&A deal has led to optimization of asset portfolio in the combined company and an increase in overall efficiency which can be a suitable measure of success.
This approach to performance is also reflected in Ching’s work on reasons for undertaking an M&A deal, discussing the industry shock theory, where a policy, regulatory or another shock leads to a change in asset values which in turn leads to transfer of assets between companies driving M&A activity, and Q-theory based on investment valuation approaches where well managed overvalued companies buy undervalued companies as it is good investment, once again reallocating assets in the process.
Defining success of an M&A deal and measuring it is still an open question for many scholars and market participants. There are many dimensions to it including short-term and long-term considerations, measures, benchmarking. Critical success factors of an M&A deal can be broken into internal and external factors. Internal factors are effective integration, accurate target valuation, adequate due-diligence, cultural alignment and sufficient talent at the target, and the external factors are economic certainty, regulatory stability and favourable market forces. Ultimately, it is a decision to be made by those involved in the deal as to how the outcome will be defined and measured.
Strategic considerations
It is important to consider the M&A strategy itself and what is the acquirer trying to achieve. M&A strategy encompasses aspects such as the type of deal that will be undertaken, the type of target pursued, the stage of the M&A wave that the acquisition is taking place during and the acquirer itself. Deal characteristics are also very important in deal success. Aspects such as whether the deal is friendly or hostile, public or private, the CEO’s attitude impact the return to shareholders at the point of announcement. Research has shown that CEO’s overconfidence leads to overestimation of value and synergies, late entry in the M&A wave where targets are generally overvalued, premiums are too high and hence underperformance post-merger (Renneboog, L. and Vansteenkiste, C., 2019).
It would make sense that industry-focused M&A are more successful than diversified deals due to existing knowledge and skills of acquirer providing it better insight into the target’s operations and better due-diligence outcomes but also due to avoidance of integration issues relating to diversifying M&A. However, there is a body of literature, notably Shoar (2002) which shows that there are synergies to be had from diversifications and such deals positively impact productivity of targets as they add value to the acquired assets.
Wave phases have an impact on the success of a deal based on the relationship between acquisition purchasing premium (APP) and net realizable synergies (NRS). Based on Clark’s (2013) wave phases, the first phase of a wave while the market still thinks it is in recession, the APP is low and NRS are high so success, if not guaranteed, then is highly probable. When the market finally realizes that it is time to buy, it is often too late as APP shoots through the roof and synergies are hard to realize as CEO’s look for PR deals rather than those which are actually beneficial for the parties involved.
It is important to consider the M&A strategy itself and what is the acquirer trying to achieve. M&A strategy encompasses aspects such as the type of deal that will be undertaken, the type of target pursued, the stage of the M&A wave that the acquisition is taking place during and the acquirer itself. Deal characteristics are also very important in deal success. Aspects such as whether the deal is friendly or hostile, public or private, the CEO’s attitude impact the return to shareholders at the point of announcement. Research has shown that CEO’s overconfidence leads to overestimation of value and synergies, late entry in the M&A wave where targets are generally overvalued, premiums are too high and hence underperformance post-merger (Renneboog, L. and Vansteenkiste, C., 2019).
It would make sense that industry-focused M&A are more successful than diversified deals due to existing knowledge and skills of acquirer providing it better insight into the target’s operations and better due-diligence outcomes but also due to avoidance of integration issues relating to diversifying M&A. However, there is a body of literature, notably Shoar (2002) which shows that there are synergies to be had from diversifications and such deals positively impact productivity of targets as they add value to the acquired assets.
Wave phases have an impact on the success of a deal based on the relationship between acquisition purchasing premium (APP) and net realizable synergies (NRS). Based on Clark’s (2013) wave phases, the first phase of a wave while the market still thinks it is in recession, the APP is low and NRS are high so success, if not guaranteed, then is highly probable. When the market finally realizes that it is time to buy, it is often too late as APP shoots through the roof and synergies are hard to realize as CEO’s look for PR deals rather than those which are actually beneficial for the parties involved.
Financial considerations
Accurately valuing the deal is crucial for the measurement of deal success. Key considerations in this undertaking are objectivity and methodology of calculation. It is the general agreement that NRS must exceed APP for the deal to be viable and thus successful. The implications include the actual calculation of both of these measures including selected methodology, feasible assumptions, access to information to estimate synergies and a degree of certainty of the future. All of these are subject to judgement of the one who performs the calculation and this brings the point to the second implication which is the objectivity of the one who does the calculations.
Earlier M&A waves have a distinct feature of being financed largely by cash outright until later leveraged buy-outs and equity deals have become more popular. The relationship between payment method and performance is based on the idea that equity is used when the firm is overvalued and an overvalued target is likely to lead to poorer performance outcomes post-merger. Mitchell and Stafford (2000) have shown empirically that companies financing their deals with equity perform worse than those who use other means. Cash carries more risk in the sense that it requires trust in the target that is being acquired to pay for it with such a liquid no-way-out asset. On the other hand, high cash stockpiles might make the acquirer careless as they have the funds to spend and their due-diligence may suffer accordingly.
Similarly, in the early stages of M&A history cash was king as credit was harder to come by. Over time, using debt to finance M&A deals has become the norm. Evidence shows that low interest rates in post-crisis periods spur M&A activity as companies find it cheap to borrow to fund their shopping sprees. In terms of post-deal performance logically, a debt-financed deal will instil more confidence as borrowing tends to discipline the borrower and motivate to accurately initially assess the synergies and also ensure they are realized in order to pay back the debt. Cash finance may be an indication of recklessness on the part of an acquirer and send the wrong message to the market but also this is the operational cash withdrawn from the business that can be harmful to working capital position and impact performance by removing the cash safety net and risking a liquidity situation at a later stage.
Accurately valuing the deal is crucial for the measurement of deal success. Key considerations in this undertaking are objectivity and methodology of calculation. It is the general agreement that NRS must exceed APP for the deal to be viable and thus successful. The implications include the actual calculation of both of these measures including selected methodology, feasible assumptions, access to information to estimate synergies and a degree of certainty of the future. All of these are subject to judgement of the one who performs the calculation and this brings the point to the second implication which is the objectivity of the one who does the calculations.
Earlier M&A waves have a distinct feature of being financed largely by cash outright until later leveraged buy-outs and equity deals have become more popular. The relationship between payment method and performance is based on the idea that equity is used when the firm is overvalued and an overvalued target is likely to lead to poorer performance outcomes post-merger. Mitchell and Stafford (2000) have shown empirically that companies financing their deals with equity perform worse than those who use other means. Cash carries more risk in the sense that it requires trust in the target that is being acquired to pay for it with such a liquid no-way-out asset. On the other hand, high cash stockpiles might make the acquirer careless as they have the funds to spend and their due-diligence may suffer accordingly.
Similarly, in the early stages of M&A history cash was king as credit was harder to come by. Over time, using debt to finance M&A deals has become the norm. Evidence shows that low interest rates in post-crisis periods spur M&A activity as companies find it cheap to borrow to fund their shopping sprees. In terms of post-deal performance logically, a debt-financed deal will instil more confidence as borrowing tends to discipline the borrower and motivate to accurately initially assess the synergies and also ensure they are realized in order to pay back the debt. Cash finance may be an indication of recklessness on the part of an acquirer and send the wrong message to the market but also this is the operational cash withdrawn from the business that can be harmful to working capital position and impact performance by removing the cash safety net and risking a liquidity situation at a later stage.
Operational considerations
Olie (1994) discusses implementation as a factor that impacts performance which is dependent on compatibility of the cultures and the extent to which the companies are willing to integrate. The consensus is that diversity of cultures reduces post-merger performance and this is even more prominent in cross-border transactions. Factors such as behaviour, values, moral beliefs and the external environment that shapes corporate cultures such as labour laws, government involvement, and economic stability all create a gap between acquirer and target cultures and the wider the gap, the harder for implementation to be a success.
Geographic distance of acquirer and target also plays an important part in the deal success. This relates to quality of due-diligence as information is easier to gather when both parties are close to each other. Another aspect of proximity is synergy rather than accessibility. A study by Uysal et al. (2008) clearly identifies that local transactions generate greater synergies and the returns from a deal where parties are close to each other are greater especially when research & development (R&D) is involved.
In the case of cross-border deals, it is expected that there would be significant differences in corporate governance structures especially if the deal involves polar opposites in terms of culture and governance approaches such as U.S. and Chinese companies. Although intuitively integration issues might arise due to cultural differences and governance approaches, Renneboog and Vansteenkiste (2019) state that there can also be benefits where a better governed company taking over a poorer governed company will lead to “governance capital” reallocation to create a synergetic effect from the transaction as better governance practices migrate to the target, are instilled at corporate level and filter down to business-process levels.
Olie (1994) discusses implementation as a factor that impacts performance which is dependent on compatibility of the cultures and the extent to which the companies are willing to integrate. The consensus is that diversity of cultures reduces post-merger performance and this is even more prominent in cross-border transactions. Factors such as behaviour, values, moral beliefs and the external environment that shapes corporate cultures such as labour laws, government involvement, and economic stability all create a gap between acquirer and target cultures and the wider the gap, the harder for implementation to be a success.
Geographic distance of acquirer and target also plays an important part in the deal success. This relates to quality of due-diligence as information is easier to gather when both parties are close to each other. Another aspect of proximity is synergy rather than accessibility. A study by Uysal et al. (2008) clearly identifies that local transactions generate greater synergies and the returns from a deal where parties are close to each other are greater especially when research & development (R&D) is involved.
In the case of cross-border deals, it is expected that there would be significant differences in corporate governance structures especially if the deal involves polar opposites in terms of culture and governance approaches such as U.S. and Chinese companies. Although intuitively integration issues might arise due to cultural differences and governance approaches, Renneboog and Vansteenkiste (2019) state that there can also be benefits where a better governed company taking over a poorer governed company will lead to “governance capital” reallocation to create a synergetic effect from the transaction as better governance practices migrate to the target, are instilled at corporate level and filter down to business-process levels.
Final thoughts
There are many aspects to consider when assessing whether a deal will be successful, some were discussed above, but also others such as interest rates, exchange rates, regulatory changes, fiscal policy, trade negotiations, geopolitics, political placement of the bidder and its connectedness in political circles, financial health of the target, competitive forces, ownership structure, management competence on both sides, public pressure, perception and management remuneration.
Each of these impacts the success of the deal and also each one impacts the different measures of deal success. The cumulative abnormal returns is the most popular measure amongst scholars and business community however, it is not the only measure and arguably not the best to judge deal outcome when synergy is the ultimate goal. Operational performance and productivity measures have their own place in the discussion of success measurement. Nevertheless, whichever measure is selected it is not just the deal closure that makes a deal successful but what happens after.
There are many aspects to consider when assessing whether a deal will be successful, some were discussed above, but also others such as interest rates, exchange rates, regulatory changes, fiscal policy, trade negotiations, geopolitics, political placement of the bidder and its connectedness in political circles, financial health of the target, competitive forces, ownership structure, management competence on both sides, public pressure, perception and management remuneration.
Each of these impacts the success of the deal and also each one impacts the different measures of deal success. The cumulative abnormal returns is the most popular measure amongst scholars and business community however, it is not the only measure and arguably not the best to judge deal outcome when synergy is the ultimate goal. Operational performance and productivity measures have their own place in the discussion of success measurement. Nevertheless, whichever measure is selected it is not just the deal closure that makes a deal successful but what happens after.
References
- Ching, K. (2018) “What Drives Merger Waves? A Study of the Seven Historical Merger Waves in the U.S.” Scripps Senior Theses. [Online]. 1-49. Available from: https://scholarship.claremont.edu/scripps_theses/1294
- Clark, P. and R.W. Mills (2013) Masterminding the deal: breakthroughs in M&A strategy and analysis. London, Kogan Page, 2013
- Maksimovich, V., Phillips, G., Prabhala, N.R., (2011) “Post-merger restructuring and the boundaries of the firm.” Journal of Financial Economics. [Online]. 102(11), 317-343. Available from: https://reader.elsevier.com/reader/sd/pii/S0304405X1100136X?token=A01040D995E10014C58FE454B0C55F2788807C434BE1F9B7CC04F983068EEB912561C9865C728D52254A0444424D72F2
- Mitchell, M. and Stafford, E. (2000) “Managerial Decisions and Long-Term Stock price Performance.” The Journal of Business. [Online]. 73(3), 287-329. Available from: https://www.jstor.org/stable/10.1086/209645
- Olie, R. (1994) “Shades of culture and institutions in international mergers.” Organization Studies. [Online]. 15(3), 381-393. Available from: https://doi.org/10.1177/017084069401500304p=AONE&u=ull_ttda&id=GALE%7CA15687865&v=2.1&it=r&sid=summon
- Renneboog, L., Vansteenkiste, C. (2019) “Failure and success in mergers and acquisitions.” CentER Discussion Paper Series No. 2019-026. [Online]. Available from: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3434256
- Schoar, A. (2002) “Effects of Corporate Diversification in Productivity.” The Journal of Finance. [Online]. 57(6), 2379-2403. Available from: https://www.jstor.org/stable/pdf/3094531.pdf?refreqid=excelsior%3Ad6f6165b33697c79527af3bdd96b4694
- Uysal, V., Kedia, S., Panchapagesan, V. (2008) “Geography and acquirer returns.” Journal of Financial Intermediation. [Online]. 17(08), 256-275. Available from: https://ideas.repec.org/a/eee/jfinin/v17y2008i2p256-275.html
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