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1 The acquired company was judged to be small if the purchase price was less than 10 percent of the acquiring company's market value. It was classified as related if the target's markets were similar to those of the acquiring company.
the target was large and in an unrelated line of business, then the success rate fell to only 14 percent.
Consistent with the ex ante results, the probability of success is also heavily influenced by the strength of the core business of the acquirer. Of the 23 percent of U.S. programs that were successful, 92 percent had high performing core businesses.
In another study, Anslinger and Copeland looked at the results achieved by 13 leveraged buyout firms and 8 U.S. corporate buyers of businesses that seemed not to have synergies with the acquirer.2 Overall, these 21 companies were very successful. They made 829 acquisitions and 80 percent believed they had earned more than the cost of capital invested in their deals. The U.S. corporate acquirers averaged more than 18 percent return to shareholders over a 10-year period, outperforming the S&P 500 during the period. The buyout firms reported that return to investors exceeded 35 percent in the period. The results provide a sharp contrast to those obtained by the typical large corporate buyer described earlier.
How did the buyout firms do it? They focused on quickly improving operating performance at acquired companies. They identified and created big incentives for the top leaders at the companies—and replaced them if their performance did not make the grade. They focused on the cash flow generated by the business, rather than accounting earnings, and used an active and interactive involvement among owners, board members, and management to push the pace of change and create a sense of urgency. Finally, many of the acquirers had their personal wealth involved in each deal. They concentrated on buying at reasonable prices, identifying concrete operating improvements, and extracting their investment within five years. This is quite a contrast to the typical large company, where management has little direct stake in a business it buys and can be easily deluded into accepting ''strategic" arguments for paying more.
Overall, the record suggests that profitable growth by acquisition is not easy, although some management teams and buyers have been successful. More often, management finds that its acquisition proposals are met with skepticism and worse by investors and by poor returns afterwards.
Reasons for Failure
Why are so many acquisitions failures? Setting luck aside, most acquisitions turn out badly because purchasers have paid too much—a situation from which it is hard to recover since it happens upfront. Another basic reason is poor post-acquisition management.
2 P. Anslinger and T. Copeland, "Growth through Acquisitions: A Fresh Look," Harvard Business Review (January/February 1996).
Why do companies overpay? Four reasons we have seen are: (1) overoptimistic appraisal of market potential, (2) overestimation of synergies, (3) poor due diligence, and (4) overbidding. No executive sets out deliberately to overpay. However, once the deal process begins, events and rationalizations prey upon even the most disciplined acquirers. The more time and effort that has gone into a deal, the harder it is to admit that it won't create value for shareholders at a given price or on particular terms, regardless of sheer business logic.
Overoptimistic Appraisal of Market Potential
Acquisition is a dangerous enterprise if based on the assumption that a market will rebound from a cyclical slump or that a company will turn around. No less problematic or uncommon is the assumption that rapid growth will continue indefinitely. Remember, if you pay a premium to acquire a company you will either need to capture synergies, improve the company's operations, or both. If you cannot do either, then you are betting against the market and the seller, and both are likely to know more about the business than you do.
We can't rule out the possibility that a company's actual value is higher than its market value. But one should be skeptical and be sure to understand where and why the market's assumptions about the future are different than yours. In fact, it is less unusual for a company's traded market value to exceed its underlying value, since at times many companies have some expectation of a takeover reflected in their stock prices. This points out the need for an independent assessment of the value of a company on a standalone basis as the essential underpinning of any deal.
Overestimation of Synergies
Synergy is a peculiar word—depending on the context it either stands for the pipe dreams of management or a hard-nosed rationale for a deal. Often it is a little of both. Consider the following example: A large health services company paid several billion dollars for a more profitable company in a related industry segment. Given its stepped-up investment base, the target's post acquisition after-tax earnings would have had to be about $500 million for the acquirer's return on its investment to approach its cost of capital. The year before the transaction was consummated, the target's earnings were about $225 million. Therefore, it needed to close an earnings gap of more than $275 million through "operating synergies." That meant more than doubling the earnings base. The acquirer's inability to make improvements of this magnitude resulted in destruction of significant shareholder value. In the ensuing three years, market indices rose while the acquirer's returns to its shareholders were actually negative. Clearly in the foregoing case, the estimation of deal benefits became disconnected from reality