WRITER: SIMON GIANNAKIS

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Intended Audience
Personal investors holding stock positions in acquisition happy companies.

Summary Points to Take Away
(1) Why companies enter into M&A activities: (a) Cost Cutting (b) Improved Bargaining Power (c) Control Premiums (d) Diversification (e) Growth.

(2) Not always the shareholders of the acquirer that get to keep the value of estimated synergies.

(3) Why worry about M&A activities: (a) Management Masking Internal Growth Deficiencies (b) Extrapolating historical growth without the costs of continuing past acquisition activity (c) Integration Issues (d) Spreading Management Too Thin.

Why Companies Enter into Merger & Acquisition Activities
The most common reasoning spread by management of acquisition hungry organizations is the value created by synergies, to be passed onto the shareholders, such as:

Cost Cutting: Value created by supporting the same revenue base with fewer capital expenditures and lower levels of operating expenses, which is usually realized through salary cutting by merging similar departments (ex. combining of marketing departments would only require one VP of marketing instead of two).

Improved Bargaining Positioning: Growing market share to improve bargaining power over suppliers and consumers, typically having a positive effect on the combined company's gross margin.

Control premiums: The additional value created by switching management, who can theoretically further utilize the company's operations beyond the level of the previous management.

Diversification: Allowing companies to branch into different industries, which spread the risk of variability of operating cash flows, resulting in a more consistent level of performance. This provides investors with greater value by providing steady cash flow with less risk of variability in operating performance.

Growth: Allowing companies with few growth opportunities to exploit opportunities available to firms with little capital to take advantage of them.

Based on the above points, it appears reasonable to assume that acquisitions can lead to the creation of value for shareholders. Empirical evidence though indicates that the acquirer typically underperforms the rest of the market in terms of returns to shareholders. Two theories behind why this is the case: (1) Value created from synergies are often realized by the shareholders of the acquired and not the acquirer (2) Synergies are over-simplified leading to an underestimate of the difficultly involved in realizing synergies.

Who Gets to Keep the Value Created by M&A Actions?
Empirical evidence shows that shareholders of the acquired firm are the main beneficiaries during merger and acquisition activities. Why is this? Bidding wars! Management of likely to be acquired companies take their case to other competitors of the potential acquirer in order to get more bids involved in the acquisition process, forcing the winner of the bidding to likely had over a substantial portion of the estimated synergies to be gained over to the shareholders of the acquired company. When considering that there is risk to realizing these estimated synergies, the risk of realizing those synergies lies squarely on the shoulders of the acquiring companies' shareholders as those of the acquired are receiving a tender offer for their shares that already includes the value of these synergies. Famed investor Warren Buffet sticks to acquiring no more than 20% of companies as purchasing the rest would bring him into a bidding war; thus, reducing the inherent value to be earned by making the purchase, as he says "We don't do bidding wars'.

What Else Should Investor's be Concerned About
Investor's should keep several factors in mind when researching and purchasing companies known as "serial acquirers":

Masking internal growth deficiencies. Management may be troubled by low organic growth rates, and in an effort to improve the growth rate to shareholders, they'll begin acquiring companies to prop up annual growth. This long term growth strategy is unsustainable though as opportunities will become scare and the fact remains that the core business is not growing on its own.

Extrapolating growth but not the cost of acquisitions. Many analysts factor in historical growth rates obtained through acquisitions into the future without factoring the cost of continually purchasing firms to maintain this growth rate. When perusing an analyst research report, keep this in mind.

Integration Issues. The majority of mergers and acquisitions face more issues and complications than expected. As an auditor, I've been on several engagements involving recent M&A activities, and from my personal experience the transition rarely goes smoothly. Issues both big and small, from conflicting corporate cultures down to integrating all staff on a common phone and internet network. The process takes years, and in some instances full integration never happens

Spreading management too thin. Upon M&A activities the acquired company's executive team is typically terminated; thus, placing additional tasks and responsibilities among the existing management team. Tends to bog them down with operational and integration issues instead of focusing on keeping the company's strategy on tract and being focused on the future, not fixing the small issues of the past and present. Management's focus changes to handling current issues instead of anticipating on how to overcome the problems of tomorrow.

Where to go from here?
If you find yourself with a position in a serial acquirer (i.e. management who make continuous acquisitions), keep the above points in mind when assessing its value. The issues noted above don't apply to all acquirers, but they are typically not the norm.

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Thanks,

Simon