M&A justifications: so what?

By Avi Deitcher

In an earlier post, we discussed the justifications, at least theoretically, for a merger or acquisition. Of course, like any financial event, whether buying a company or buying an iPod, the numbers have to make sense. Put in other terms, you have to gain more out of it than you put into it (in business terms, being profitable), otherwise you simply do not do it. In this discussion, we will examine some of the financials behind these events, and how they are justified.

In general, you buy something because it is worthwhile to you. If that something is not a simple expenditure (like an iPod), but rather an investment, you do so because you expect to make a return on that investment. The obvious question is, in the case of an acquisition, shouldn't the net return be neutral? In short, if a company's profitability (and, more importantly, its free cash), is worth $500MM right now, then shouldn't its price be exactly $500MM? If so, if you spend $500MM, you have gained nothing; if you spend greater than $500MM, you have lost money, and if you spend less than $500MM, well, the current owners will not sell, since they make more money by holding onto the company, at least until a better buyer comes along.

The core to understanding this is the integration value discussed in the previous article. We will use the horizontal integration example of earlier with two car companies. In that case, the competing companies may well have been worth $500MM each as they stand today, but since each one will cut $5,000, or 25%, of their expenses by working together through economies of scale, when joined each is worth some amount more than $500MM, say, $600MM. Thus, the buying company will pay something more than $500MM, to make it worthwhile for the sellers, and less than $600MM, to make it worthwhile for the buyers. Everyone wins (except for the remaining competitors, who now face a stronger player, but we are not too concerned about them). From a growth perspective, using the cross-selling example, if each company, again, is worth $500MM, but together, without having to cut any costs, they can grow their revenues and hence their profits by 20%, then each one, when joined together, is worth $600MM, or 20% more. Thus, the acquiring company will pay something more than $500MM, to make it worthwhile to the sellers, and something less than $600MM to make it worthwhile to the buyers.

As we can see from the above financial examples, mergers and acquisitions really only make sense in one of two cases:

 

  1. Where the value of integration is great enough that the acquirer can pay more than the current value of the company, yet still have a positive return on the investment, such that the company standing alone could not gain this new value.
  2. Where the existing company is so poorly run that the current value is significantly below what the value will be when the new owners turn it around and fix it up.

 

The final twist in this is the operational cost of the transaction. In addition to the significant sums to pay to acquire (or merge with) the company, there are operational and transactional costs:

  1. Investment banker fees
  2. Legal fees
  3. Regulatory fees
  4. Employee severance
  5. Facilities mergers
  6. Accounting mergers
  7. IT systems mergers
  8. Benefits management

 

The list goes on and on.

So why, in the end, do so many mergers and acquisitions fail? The short form, of course, is that the cost paid plus the operational costs is greater than the value the managers/owners perceived they could extract from the merged entity. The obvious question, then, is why are these numbers off for so many transactions? A follow-up post will discuss this issue.