18 January 2019

Many corporate deals fail. But Professor Jo Danbolt argues they can work if they are made for strategic reasons, rather than in response to external pressures.

More than 49,000 mergers and acquisitions (M&A) were completed between companies around the world in 2018. Worth close to $4 trillion (a million million US dollars), the value of these transactions almost matched levels last seen before the global financial crisis.

M&A can offer significant cost savings through increased economies of scale, and a faster way to gain market share and reduce competition than organic growth. It should also lead to higher returns for shareholders and benefits for customers and the wider economy.

Yet the evidence indicates these deals often fail to deliver on their promises. One influential study found acquisitions have a positive impact on bidding companies’ share prices in just two-fifths (41%) of transactions. Other research suggests companies underperform their peers on average between 11% and 25% during five years after they buy another business.

These transactions are not always as strategic as they ought to be. When a publicly traded company buys another, it is not uncommon for it to pay up to 30% more than the value of the target business’ share price to persuade shareholders to sell. Deals such as these must offer benefits that outweigh the additional costs, in order to be successful.

However, for some CEO’s the lure of empire building trumps the risk of a bad investment. M&A advisors and investment banks make money through these transactions, so may also present opportunities in a positive light to maximise their returns. Sometimes deals are a response to a fear of hostile takeovers; the ‘buy or be bought’ mentality.

Shareholders in the company being acquired often receive more than their shares are really worth, and the bidding company pays too much. The Royal Bank of Scotland’s near collapse in 2008 followed its acquisition of Dutch Bank ABN Amro for a hefty £49 billion, just a year earlier.

There is also evidence of firms managing their accounts to increase their valuation. Soon after Hewlett Packard acquired British software company Autonomy for $11 billion in 2011, the US firm wrote off $8.8 billion due to significant accounting irregularities.

My own research suggests contingent payments may be an effective way to manage the risk of overvaluation.

However, such pitfalls are rare and can be avoided with prudent planning. My own research suggests contingent payments may be an effective way to manage the risk of overvaluation. Known as ‘earn-out contracts’, these allow the buyer to pay incrementally over a period of years when certain performance milestones, such as revenue targets, are met.

I remain optimistic about the value of M&A, and while many bidders overpay, acquisitions overall create economic benefit and value. Strategically-aligned transactions can be an effective way for companies to grow, invest, and innovate.

The average failure rate of M&A may also hide as much as it tells us. We have little data to examine how successful it is for small and medium-sized firms, whose shares are not publicly traded.

As with any investment, M&A can only be successful if it is well thought through and aligned to strategic goals. Hubris, greed, and ego have no place at the negotiating table.

Jo Danbolt

Professor Jo Danbolt is Baillie Gifford Chair in Financial Markets at University of Edinburgh Business School. He will lead a week-long Financial Aspects of Mergers and Acquisitions MBA Option course at University of Edinburgh Business School, from 22 – 26 April 2019.

Financial Aspects of M&A Option Course