Investment Banking: Why Many M&A Deals Go Wrong
Two investment banking teams can draw dramatically different conclusions even when presented with an identical set of facts and data to analyze. While it may seem like much of the analysis of mergers and acquisitions involves the application of financial models and is very cut-and-dried, mathematical, and technical, a great deal of art is involved in the deal.
Even though many very intelligent people work on M&A deals, the deals can and often do go bad for a myriad of reasons.
Some mergers and acquisitions simply shouldn’t see the light of day because they’re basically bad ideas from the start. But there are incentives all around to get a deal done — a successful M&A deal results in many individuals getting paid and others, notably the management of the acquiring firm, building a bigger empire to oversee.
So, some of the analysis may not be unbiased, but may be influenced by other factors. Recognizing when those factors are at play is difficult, however, because there is a great deal of judgment involved in the due-diligence and valuation processes.
Some M&A deals fail to materialize when they actually should have been done. Some firm boards and management teams are so concerned with their personal positions that they fight potential suitors when it’s in the shareholders’ best interests to pursue the business combination.
That’s why many investors support management having large personal stakes in the equity of their own firms. Such an equity stake seeks to align the incentives of management with those of the shareholders and provides them with an incentive to act in the best interests of the shareholders.
The financial models that are used by investment banking firms are very standard discounted cash-flow and relative valuation models — standard fare in the industry. Rarely is the analysis faulty because improper models are being applied.
A simple tweaking of an assumption here or there in the analysis — perhaps a sales growth rate that is a couple percentage points higher or a discount rate that is a couple percentage points lower — can make all the difference in the world when it comes to making a transaction appear profitable or unprofitable and providing the client with the answer they want to hear.
Forecasting future cash flows is very difficult, especially out several years in advance. Yet, much of the modeling in an acquisition setting requires investment bankers to do just that — predict the future.
Falling into a false sense of security when analyzing the numbers that result from the due-diligence process is quite easy. There is an “illusion of precision” because the modeling is so complex that people believe that the valuations arrived at must be accurate. This is the same situation that investors encounter when trying to determine if a particular share of stock is over- or undervalued.
And it’s precisely why many of the most successful value investors in the world demand a large margin of safety before they commit their funds. They want to know that even if they were a little too optimistic in their assumptions, the deal will likely turn out in their favor.
Many companies are so anxious to do a deal that they accept even marginal deals with little or no margin of safety. This kind of thinking is exacerbated when there is a lot of M&A activity — firms don’t want to miss out on all the good deals.
Some mergers and acquisitions fail because the investment bankers and management teams are simply overly optimistic about the synergies that can be achieved. In fact, over-optimism may be the single biggest reason that shareholders are disappointed with the results of a merger or acquisition. The benefits described on paper are not realized and simply can’t be translated into the real world.
Many mergers and acquisitions are unsuccessful because of the difficulty of integrating companies with distinctly different firm cultures. Bringing two firms together to operate under a single umbrella involves more than just combining assets and liabilities on a balance sheet — it also involves bringing people together to work productively with each other.
The winner’s curse: Overpaying
Just like the individuals in the popular TV series Storage Wars, corporate executives find themselves in bidding wars to acquire firms and go beyond the prices that they rationally set for the target company.
Initially they set price limits at which the acquisition makes good economic sense for the shareholders. But, as soon as they get into a bidding war, it’s no longer just about acquiring the firm for a price that makes economic sense — it’s about winning…at virtually any cost.
Economists have coined the phrase “the winner’s curse” to explain the phenomenon in which the winning bidder in an auction is the one who most overestimates the value of the item being auctioned. This explains why, on average, academic studies show that acquisitions are good for the shareholders of the target firm (the company being acquired) and bad for the shareholders of the acquiring firm.