circles of executives, consultants, and journalists, that M&A destroys value. Consider some statements culled from a recent work by consultants in M&A:
The sobering reality is that only about 20 percent of all mergers really succeed. Most mergers typically erode shareholder wealth … the cold, hard reality that most mergers fail to achieve any real financial returns … very high rate of merger failure … rampant merger failure….1
A manager should find these assertions alarming, not least because of the large business- and public-policy implications they might have. But the findings of a broad range of scientific studies are not consistent with the language quoted here if one uses definitions of “success” and “failure” rooted in economics, and tested using conventional statistical methods. One possible reason for the disparity between popular perception and scientific findings is confusion about what it means for an investment “to pay.”
This book uses a specific benchmark for measuring performance: investors’ required returns, commonly defined as the return investors could have earned on other investment opportunities of similar risk. Against this benchmark, we can define three possible outcomes:
1 Value conserved. Here, investment returns equal the required returns. Shareholders get just what they required. The investment has a net present value of zero; it breaks even in present value terms. This does not indicate an investment failure. If the investor requires a return of 15 percent, and gets it, his or her invested wealth will double in five years. Under this scenario, wealth will grow at the rate the investor requires. Economically speaking, the investor earns “normal” returns. The investor should be satisfied.
2 Value created. This occurs where the returns on the investment exceed the returns required. This investment bears a positive net present value; the investor’s wealth grew higher than was required. The investor must be very happy. Given competition in markets, it is difficult to earn “supernormal” returns, and very difficult to earn them on a sustained basis over time.
3 Value destroyed. In this case, investment returns are less than required. The investor could have done better investing in another opportunity of similar risk. The investor is justifiably unhappy here.
Notions of success or failure should be linked to these measurable economic outcomes. In economic terms, an investment is successful if it does anything other than destroy value.
Why should we focus so narrowly on economics? Many managers describe a complex set of motives for acquisitions—shouldn’t the benefit of M&A activity be benchmarked against all of these? The use of broader benchmarks is debatable for at least two reasons. First, the managers’ motives may be inappropriate, or the managers themselves foolhardy. One hears of M&A deals that are struck for vague strategic benefits, the creation of special capabilities, the achievement of competitive scale, or because two organizations or CEOs are especially friendly. But the only way one can prove that these are actually beneficial is by measuring the economic outcomes rigorously. Second, special deal-specific definitions of success limit generalizing from the research findings. Enhancing the welfare of shareholders is a fundamental objective of all firms—indeed, in the United States, corporate directors are required to implement policies consistent with shareholder welfare, usually synonymous with creating value. Fortunately, benchmarking against value creation does permit generalizations to be drawn. Indeed, the definition of M&A success and its drivers is a fertile area for further research. I pursue the narrow economic question here in hope of saying something meaningful and tangible that is grounded in scientific research.
There are two primary parties to an M&A transaction: the buyer and the seller of the target company. In addition, there are numerous ancillary economic interests in the deal, those of advisors, creditors, suppliers, customers, employees, communities, governments, and so on. This survey will focus mainly on the consequences for the shareholders of the two primary parties. This is not to deny the relevance of other interests, but to acknowledge the fiduciary responsibility of boards of directors to their shareholders (above all others). The possible transfer of wealth among shareholders and other groups in a deal is a very interesting topic, on which there is little rigorous research. Of course, private and social interests can diverge, as the “problem of the commons” illustrates.2 M&A activity may affect a variety of influences on the common good, including industry concentration and monopolies, international competitiveness, productivity growth, and technology transfer. The research literature on these aspects, however, parallels the more narrow discussion here about shareholder welfare. For brevity, therefore, the discussion here does not survey the impact on other stakeholders.
MEASUREMENT OF M&A PROFITABILITY: BETTER THAN WHAT?
There is no free lunch, said Nobel laureate Milton Friedman. One of the basic conclusions of economics is that where markets are reasonably competitive, players will earn just a “fair” rate of return; you just get paid for the risk you take. The intuition for this is simple: Where information is free-flowing and entry is easy, a firm earning very high returns will draw competitors, as honey draws flies. The entry of these other firms will drive returns down to a point at which the marginal investor just gets a fair rate of return. This idea has been tested extensively in financial markets and leads to the concept of market efficiency, that prices will reflect what is known quickly and without bias. Whether a free lunch exists in M&A hinges on returns to investors, and like the tests of capital market efficiency, could be gauged in three classes of measures, sketched in Exhibit 3.1:
1 Weak form. Did the share price rise? Are the shareholders better off after the deal than they were before? For instance, this would compare whether the buyer’s stock price was higher after the deal than before. This before-and-after comparison is widespread, especially in the writings of journalists and consultants. But it is a weak test because it fails to control for other factors that might have triggered a price change, unrelated to the deal. Stock prices are driven by random noise, marketwide effects, and other firm-specific events, of which firms generate a lot. As an exercise, pick a merger announcement, and then do a scan of all the news stories that pertain to the firm for several months or years afterward. The odds are that the merger will be a minute portion of the news that drove your firm’s share prices. For this reason, weak form tests are notoriously unreliable.EXHIBIT 3.1 Classes of Tests of M&A ProfitabilityTestStructure: M&A Pays If:Description and CommentsWeak formPAfter > PBeforeDoes the firm’s share price improve from before to after the deal? A comparison widely used by consultants and journalists. Unreliable. Vulnerable to confounding events at the firm and marketwide effects.Semistrong form%RM&A Firm > %RBenchmarkDoes the return on the firm’s shares exceed that of a benchmark? Widely used by academic researchers. Depends for its integrity on good benchmark selection and large samples of observations.Strong form%RFirm with M&A > %RFirm without M&ADoes the return on the firm’s shares exceed what it would have been without the deal? The “gold standard” test, but unobservable.
2 Semistrong form. Did the firm’s returns exceed a benchmark? Are shareholders better off compared to the return on a benchmark investment? Introducing a benchmark like the return on the S&P 500 index, or the return on a matched sample of peers that did not merge, strengthens the analysis. This kind of test, widespread in academic research, dominates the weak form tests because it controls for the possibility that the observed returns were actually driven by factors in the industry or entire economy, rather than due to the merger. But this kind of test is at best semistrong because benchmarks are imperfect. For instance, which firm would have been a good benchmark comparison to Walt Disney at the time of its acquisition of ABC Cap Cities? We could name some entertainment and real estate firms, but at the end of the comparison, we should still harbor some unease about noise and confounding
