Mergers and Acquisitions: The Market for Companies. An Application of 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 merger broker and took part in 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 regret.” 

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. 

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.

ASYMMETRIC INFORMATION AND ACQUISITIONS

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 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 ally.

Mergers and Acquisitions (M&A)

In addition to the development of innovations and internal growth as a source of growth for corporations and the formation of oligopolies, large corporations are often formed through mergers and acquisitions.

"Merger Mania" in the late 19th century, often promoted by J. P. Morgan and culminating in 1895-1904, created many of America's largest companies. Many would continue to dominate their industries well into the late 20th century.

One indication of the continuing impact of mergers among large companies and acquisition of smaller companies is the decrease in the number of publicly traded companies. In the mid-1990s, there were around 8,000 publicly traded companies in America. In 2016, the number had fallen to 3,627.




For many years recently, America’s corporations have spent more than $1 trillion a year on mergers and acquisitions. Globally, M&A is around $3 trillion a year. Some of the largest mergers recombined companies that were broken up in earlier anti-trust cases. Cross-border and cross-regional mergers and acquisitions are creating global companies, called multinational corporations (MNCs).

The result is increasing concentration. Two finance professors at the University of Southern California estimate that nearly a third of American industries were highly concentrated in 2013, up from a quarter of all industries in 1996.

Many of America’s 500 largest corporations spend more money every year on mergers and acquisitions than on net capital investment. 

Why? What are they buying?

Some mergers are between large corporations to reduce combined costs, reduce competition, merge related product lines or realize some economies of scale. Many large companies acquire smaller companies to eliminate potential competition, acquire new technology, acquire more innovative managers and employees, expand product line, or expand markets to other countries. While the United States and other countries have anti-trust laws, they are seldom used to block mergers or acquisitions. Governments often tolerate or even encourage mergers, believing larger companies are necessary to compete in regional (EU) or global markets. 




While most merger and acquisitions do not make financial sense – they do not earn the companies' cost of capital – they may make sense from a strategic point of view by eliminating actual or potential competition.

Acquisitions of competitors or new companies that have specialized knowledge or are perceived as a current or potential threat is another defensive strategy to preserve market positions over time. Acquisitions, seldom a good investment, are the cost corporations pay for stability and long-term survival.