Chapter 15 - The Market for Companies: Acquisitions and Asymmetric Information

Chapter 15
THE MARKET FOR COMPANIES:  ACQUISITIONS AND ASYMMETRIC INFORMATION


 INTRODUCTION

I was, for many years, in charge of finding and analyzing acquisitions for a large company.  Then, for two years, I was an independent consultant and took part in acquisitions negotiations.

MERGERS AND ACQUISITIONS

American corporations spend over $1 trillion a year buying other companies.  This is more than they spend on net new investment.  Even more than they spend on boxes at pro sports stadiums.

Buying another company is a risky corporate strategy.  The few studies I have read indicate that 70-80% of acquisitions are failures.  They do not earn the acquirer’s opportunity cost of capital.  Many are a total loss and result in future write-downs.  

This failure rate from published research is similar to the information I collected.  My department would use discounted cash flow/net present value analysis to determine the maximum price we would pay for an acquisition (the present value of the future net cash flows).  We kept a running list of companies that were potential acquisitions.  Most were eventually acquired by other companies.  A high percent, over 80%, were acquired for a price above our maximum price.

Because of the high risk of an acquisition, we were probably conservative in our forecasts of future cash flows.  As a check, we did sensitivity analysis and learned that the present value of a company was sensitive to small changes in sales growth rates and operating margins.

Why such a high failure rate?

The first reason is that the buyer pays too much, making it unlikely the buyer can earn an acceptable return on the investment.  Many of the acquisitions were of public companies.  Finance theory says that the current price is the best estimate of expected future cash flows.  Yet acquiring companies routinely paid 30%-60% over market price.  Why?

Usually, the acquirer goes after the acquired.  This gives the seller a negotiating advantage.  If they are smart, they will appear reluctant to sell, hoping to be “convinced” to sell at a high premium.

From a seller’s viewpoint, the best situation is when two or more acquiring corporations get into a bidding war.  Financial rationality goes out the window.  Remember, companies are headed by people who are very competitive.  They don’t like to lose.  An auction starts.  The winner often pays too much and learns about another concept – “winner’s remorse.” 

This can happen even if there is only one bidder since the seller doesn’t have to sell.  The seller can hold out for a very high price, knowing that once the company is “in play,” other potential acquirers will become interested.  

If the intended acquisition is a public company, the acquirer has to pay some premium to ensure all or almost all of the stockholders sell their stock.  Another reason is that the acquiring company may  believe the acquisition is worth more to them than to outside investors.  Maybe the company has a key technology or specialty product the acquirer needs.  Maybe the acquirer could bring something that would add value to the acquired, such as wider distribution of a regional or specialty consumer product.  Maybe the acquirer is eliminating an actual or potential competitor.

 Many mergers are defensive.  If a company's competitors, suppliers or corporate customers are merging, becoming bigger with larger market share, the company will be under pressure to also become bigger through merger or acquisitions. This motive and the example of the health care industry was discussed in The New York Times Discovers Bilateral Oligopoly section of an earlier tutorial, Bilateral Oligopoly.  

Maybe the acquisition is highly valued because of the entrepreneurial management the acquirer lacks. Wal-Mart just paid over $3 billion for a small online retailer that is losing oodles of money.  A look at Wal-Mart’s Ecommerce site will tell you why.  Wal-Mart is betting $3 billion now and billions more in the future that the founder of jet.com knows how to compete with Amazon.  Good luck. 

These are potential added benefits compared to the current cost of the acquisition.  They are uncertain.  Acquisitions are risky for another reason, summed up in the concept of asymmetric information.

ACQUISITIONS AND ASYMMETRIC INFORMATION

Who knows more about the intended acquisition, the buyer or the seller?  The seller. Why?  The seller knows the risks, where “the bodies are buried.”

The buyer will try to discover the risks through a process called due diligence.  The seller must make its financial records available to the buyer.  But financial records seldom indicate the risks.  The buyer’s owners and managers have no incentive to divulge any adverse information; on the contrary, they have a strong personal incentive not to divulge negative information.

The seller knows more about the company and also more about the industry – the competitors, the technology and future sources of risk.

POST-ACQUISITION RISKS

Imagine that you and your friends started a company.  You worked very hard – 12-14 hours a day, 6-7 days a week – and ploughed profits back into the company.  You took modest salaries.  The company grew rapidly.  One day there is a knock on your door.  A large corporation wants to buy your company.  The price will make you and your friends rich.  Seriously rich.  Now what happens?

You and your management team are now managing a small piece of a large company.  Rather than running the show yourself, you now report to a Senior VP in a big city far away.  There are budgets, reports and meetings.  Proposed capital expenditures now go through a long, formal process; you compete with other parts of the corporation for capital. Clueless corporate staff types with MBAs from Harvard review your requests and decisions.  High-risk proposals are denied.  After a few years of this, what do you and your friends do?  Walk.  The main reason the large corporation bought you, what made you attractive, just walked out the door, taking most of the value of the company with you.

This scenario is very common.  Even a less drastic scenario is likely.  Do you work as hard?  As many hours?  Don’t you want to enjoy your new-found wealth?  Buy the Porsche you always dreamed about and zip down the Pacific Coast Highway to Big Sur and enlightenment?  Go to comic book conventions? Maybe divert your attention and energy into pursuits that bring you status?  Part-owner of a professional sports team?  Board membership at a prestigious museum or orchestra?  A vineyard in Sonoma Valley?  The new possibilities are endless.

And the ultimate nightmare to the acquirer.  You and your friends get to hate your corporate superiors and their petty, bureaucratic mentality.  So you walk out and start another company in competition with them.  You have tons of money, a proven track record and every VC in the Valley wants a piece of your new company.  You know everything about your old company and its owners know nothing about your new company.  Asymmetric information is still your friend.


Comments

Post a Comment

Most Popular Posts

Adam Smith's Pin Factory

Image
ADAM SMITH VISITS A PIN FACTORY   Adam Smith’s description of a pin factory is on the first page of  The Wealth of Nations .  (Chapter 1 – “Of the Division of Labour”)  Drawings of pin factories of this period show workers using hand tools. Smith says the process can be broken down into 18 distinct steps, including packaging the pins. Smith mentions that pin factory workers were poorly paid, despite their high productivity.    Adam Smith says he visited a pin factory employing 10 men who produced 48,000 pins per day.  If each of the ten workers had done all the steps themselves, Smith says each worker could produce only 10 or 20 pins per day.  So the pin factory replaces 2,400 to 4,800 pin makers. The increase in labor productivity (output per person per day) is as high as 50 times that of individual pin makers.     This reduction in unit cost or average cost (AC) and the huge increase in quantity produced do not just replace older methods of organization and production.  They increa
Read more

The Structure of the Economy: Bilateral Oligopoly

Image
DEFINITION OF A BILATERAL OLIGOPOLY Models of market structure assume that the demand side is represented by a large number of buyers.  The structure of the market, and the assumed market outcomes, depends on the number of suppliers and how they compete.  Suppliers either post one price or exploit their knowledge of buyer categories by using price discrimination.  Despite the comments about the key role of consumers in determining economic performance, consumers are fairly passive when the discussion focuses on imperfectly-competitive industries.  But many markets are not structured this way; the buyers are not passive consumers but large corporations that do not passively accept suppliers’ prices.  Net prices are actively negotiated.  These markets are often bilateral oligopolies. In a bilateral oligopoly the buyers are not an undifferentiated mass of consumers but rather a small number of purchasing agents or professional buyers representing large purchasers.   T
Read more

The Stock Market Crash of 1929 and the Beginning of the Great Depression

Image
Famous Headline Introduction The usual reasons given for the Great Depression – the stock market crash of 1929 and the later collapse of the banking system – do not tell the whole story. Available economic data indicate (there were no national income accounts in 1929) that a recession had already begun before the stock market crash. The crash of October and November of 1929 was a catalyst that made the recession worse but the partial stock market recovery in early 1930 did not end the recession. Industrial production continued to fall quickly and unemployment rose rapidly in 1930. Continuing farm and businesses failures over the next two years wiped out thousands of small rural banks and threatened total financial collapse in early1933.  For a fuller explanation, we have to go back to the 1920s to see additional reasons for the origins and the rapid decline in output at the beginning of the Great Depression. We have to look at the internationa
Read more

Guide to Pages and Posts

PAGES - ECONOMICS TUTORIALS This set of economic essays in Pages are equivalent to a course in economics. They emphasize the dynamics of economic growth and development, and the role of information in the functioning of modern markets. BASIC CONCEPTS AND THEORY Chapter 1 - Introduction and Summary The Beginning of the Industrial Revolution   in England       Chapter 3 - Economic Development and Economic Growth Chapter 4  - Production Functions and  Supply Chains Chapter 5 - Demand, Income and Consumption Chapter 6 - Competition, Strategies and Structure Chapter 7 - Imperfect Competition: How Large Corporations Compete Chapter 8  - Case Study:  Parker Hannifin Chapter 9  - Bilateral Oligopoly Chapter 10 - Examples of Bilateral Oligopoly Chapter 11  - Critique of Basic Economic Theory MARKET DYNAMICS AND INFORMATION:  HOW MARKETS WORK Chapter 12  - Introduction to Information and Economic Structure Chapter 13  - How Markets Work:  Transaction Costs and Market-Makers Chapte
Read more

Explaining Derivatives - An Analogy

Image
You go around to farmers with cows. You buy all the cows and pay the farmers a small fee to milk the cows and sell the milk. You pay for the cows with ass(et)-backed securities called MBSs (Milked Bovine Securities) that you tell investors are udderly safe. But some of the cows don't give enough milk (cow flow problem) or give no milk at all. You take some of the asset-backed securities, say they're backed by the subprime cows, and use them as collateral to sell another set of securities called CMOs (Cow Milk Obligations). Then you buy CDSs (Cow Dried-up Swaps) from AIG (Angus Insurance Company) to insure the CMOs when the cows stopped giving milk. If you work it right, you collect more on the CDSs than you pay out to retire the CMOs. The money you get from selling the dead cows go to pay the CLOs (cow leather obligations). You could also sell CDOs (cow dung obligations) that depend on how much cow dung is produced. This is a typical Wall Street product - turning sh
Read more

Government Finance 101: Welcome to Alice in Wonderland

Image
    Fiscal Policy   Some basic definitions:   Deficit.    The difference between the federal government’s spending and its revenue in one fiscal year.   The fiscal year starts on October 1.  So fiscal year 2024 started on October 1, 2023. You know right away this is going to be confusing. Yearly deficits before the coronavirus were around $1 trillion per year. For fiscal year 2021, the deficit was $2.8 trillion. Total stimulus spending and tax cuts were around $4 trillion. The Congressional Budget Office’s latest projection is an average yearly deficit of $1.5 trillion for the next 10 years. This should be viewed as a minimum.   Social Security and Medicare are funded by their own taxes and working down their trust funds (selling government bonds). Subtracting Social Security and Medicare taxes from the Federal budget, other revenue covers about 50-60% of all other government spending; the other 40-50% is the deficit and financed by borrowing.   Debt .  Short for national debt.
Read more

John von Neumann Sees the Future

Image
John von Neumann JOHN VON NEUMANN CREATES THE FUTURE If you want to understand the world we live in, you have to know about the thinking of three men – Alan Turing, Claude Shannon and John von Neumann.   I’ve talked a little about Alan Turing in an earlier essay.   All three men knew each other, discussed their ideas with each other and promoted each other’s ideas. John von Neumann has been called the smartest individual of the 20 th Century.   Even an outline of his accomplishments, which you can read about in  Wikipedia, is hard to believe.   He invented game theory, which I discussed in two earlier posts.   He headed up a group of mathematicians who invented new statistical techniques at Los Alamos that made the atomic bomb possible.   In 1944, he wrote a memo that outlined the structure of the modern computer.   He then managed the design and building of a modern general computer and consulted on the building of virtually all the early computers. JOHN VON NEUMANN
Read more

The Roman Republic Commits Suicide: A Cautionary Tale for America

Image
Why Study Rome? Americans have focused on comparisons between Rome and America twice in American history.  The first time was during the period from before the Revolution to after the ratification of the Constitution and Bill of Rights, when the founding fathers and others looked to the Roman Republic for ideas and inspiration on how to structure the new government. After the American Revolution, the founding fathers, having read the Roman authors detailing the collapse of the Roman republic, worried about internal threats to the survival of their new republic.   The second time was when the United States became a superpower, especially after WWII, and then again after the collapse of the Soviet Union in 1991. Commentators compared America to the Roman Empire at the height of its power. There was some discussion about how America became a permanent warfare state and how it affected domestic democracy and civil society. And now a third time. Hav
Read more

“Pax Americana”: The World That America Made

Image
There are two kinds of empires: the kind that rules through ruthless exploitation, and the kind that seeks to induce allies into defending themselves through economic incentives. (George Friedman) INTRODUCTION America's power and influence in the world rests on three broad, interrelated bases: 1) Overwhelming military power that can be projected anywhere in the world,     supplemented by security arrangements with allies and supporters. 2) A large, innovative, dynamic domestic economy as the basis for global economic and technological leadership. The economy provides the resources and technology to support the military and a global foreign policy. 3) Claims to moral and ideological leadership and influence, particularly the promotion of liberal democratic societies and supporting political institutions. This post will discuss the economic aspects and related security objectives of American foreign policy. It will focus on the structure of the global
Read more