The seven worst reasons for paying a premium on an acquisition

Managers use a multitude of reasons to justify paying excessive premiums on acquisitions – here are some of the worst:

1. Acquiree managers will not recommend the deal to shareholders unless a premium is paid.
It’s great when an acquirer states they will respect the status quo and ‘not change a thing’. Great – sure. True – almost never. You see, in order to realise synergies something has to change – if both companies are run precisely as they were independently, by definition, there is no value creation. As such, M&A deals almost always result in reorganisation – and for incumbent management of the acquiree (and there is always an acquiree even in a ‘merger’ of supposed equals), this normally means loss of power, income or ultimately jobs.

This ‘principal-agency’ issue creates conflicting incentives for owners who would be expected to accept an offer that reflects a premium over fair value, and managers who face potential job losses. As such, managers may feel no pressure to recommend a deal unless a substantial premium is paid.

However, acquisition premiums are not a replacement for credible corporate governance – and do not be surprised if your market cap drops if you pay a premium for this reason.

2. Mistaking value transfer for value capture.
One of the most common mistakes made in M&A is confusing value transfer for value creation. In May 2004, General Electric agreed to buy Universal Entertainment from the French media conglomerate, Vivendi. Historically, the two companies had a long standing relationship stretching back to the 1950’s – NBC would purchase and distribute Universal content. In their 2003 annual report, General Electric (NBC’s owner) commented on the deal: ‘Over the years, we have built a strong NBC franchise. However, broadcast television will be impacted by changes in entertainment technology and distribution, and we felt that NBC could not stand still. Universal adds tremendous assets to NBC, including great content, attractive cable services, a leading film studio’. A leading pundit wrote in the New York Times at the time: ‘I think there is real synergy…you will see a company that has both ends of distribution and syndication which creates synergy’.

The argument put forward was that by purchasing Universal, NBC would have control over Universal content ‘for free’. However, NBC was sucked into a control illusion – instead of paying for content through individual transactions in the market, NBC simply paid upfront in the form of acquisition price. There was no value creation here, General Electric simply moved moved money from one pocket to another. Furthermore, whereas prior to the deal, Universal was able to sell content to the highest bidder – be that NBC, Fox or any other network, the ‘merger’ prejudices the price Universal receives, destroying value.

3. Our Consultants/Investment Bankers say this is the right price.
Full disclosure: I have worked as a management consultant (I am pleased to say I have put this shady past behind me) and have advised companies on M&A deals. So, I am not saying a consultant or banker’s recommendation should lead a manager to avoid a deal – however, it is vital to understand the incentives of those whose counsel you keep.

M&A is a caveat emptor world – sure, take advice when doing a deal, but make sure you do your due diligence and run your own numbers. When the deal is done and dusted – you will be the one left to realise value from the acquisition (with the help of ten 28 year-old consultants from McKinsey, charged at £5000 p/d, of course).

4. We can ‘afford’ to pay a premium as the value of synergies is more than the premium we are paying.
Synergies are at the heart of M&A deals. Acquirer’s know this – and more importantly, so do acquirees, and rightly or wrongly, they may well want a slice of your pie.

However, before you start paying away synergies, be sure to remember two facts: Firstly, there has been a historic tendency to overvalue of synergies, and secondly, realising synergies has proven hard – very hard – history is full of high-profile M&A deals that started with the promise of synergies but ended bitterly, without any of the promised fruits ever tasted.

For example, Quaker Oats bought drinks maker Snapple in 1994 for $1.7bn, promising to realise distribution efficiency and revenue growth opportunities – Snapple was spun off 2 years later at 20% of the price. In 2002, AOL and Time Warner merged in a $350bn deal – the biggest deal in history, promising to transform the media and entertainment industries. However, write-downs and losses resulted in a near 100% loss in shareholder value.

The point is deals fail – according to research three-quarters of M&A deals fail to create shareholder value. Paying away synergies to an acquiree on the guarantee they will be realised in the future is an exercise in gross naivety.

5. We have excess cash
The Economist, recently ran a story stating macroeconomic conditions are ripe for a surge in M&A activity. The rationale was, during the crisis, firms built up record reserves – which must now be spent and ‘If they don’t spend them, investors will demand bigger dividends or share buy-backs’.

However, in most cases, returning this excess cash back to shareholders is precisely what should be done – if a firm does not have new projects available that are able to earn at least a return equal to cost of equity then doing anything but returning the cash back to shareholders will destroy value. Not doing so is an abuse of the agency role to act in the interests of the owner.

6. Diversification
The ‘diversification’ argument is often cited by executives for M&A deals. For example, firms operating in an industry with poor growth prospects or a high degree of volatility attempt to control macroeconomic forces by purchasing a firm in an unrelated industry. However, diversification with the aim of controlling macroeconomic forces does not create value for shareholders, as purchasing stock in unrelated companies easily (and less expensively) achieves the same aim.

7. To win
‘Murders and Executions’. This is how Patrick Bateman describes his job as an M&A banker in the film American Psycho. And for for many managers M&A is war – normally between the acquirer and the acquiree, or, between multiple potential suitors and the darling acquiree. In either case, managers often become embroiled in a battle to win – at whatever price. Paradoxically, the appearance of potential bidders normally leads to a situation where each bidder believes they must win – justifying higher and higher bids by the fact that if the competitor wants it so bad, then there must be a massive pot of gold there somewhere. What you end up with is a classic example of ‘winner’s curse’ – where the only winners are the acquiree owners (and the bankers – lest we forget them).

So, there you have it – the 7 worst reasons for paying a premium on an acquisition. If you here any of them being used (and you will) it’s time to reevaluate your investment decisions.