If we look at the historic pattern, M&A activity moves with the stock market cycle, yet current activity levels are lagging the markets. Clearly, levels of cash on balance sheets are at very high levels and, within the UK, leverage ratios are at multi-year lows, which will make financing any M&A activity easier. All these point to a potential resurgence in M&A activity.
Signs of M&A life
There have been some signs that company managements are starting to view the future more optimistically, with flickers of life on the takeover front. In the UK we have seen Schneider’s bid for Invensys, Polymer’s bid for Fiberweb, and Amec’s ultimately unsuccessful bid for Kentz, and its more recent bid for Foster Wheeler.
Comparing M&A activity relative to the broader market from a behavioural perspective, one obvious feature is that companies typically make more acquisitions in a rising market than they do at the bottom – the opposite of the ‘buy low/sell high’ route to value creation.
So while M&A activity may be good news for the market overall, and will clearly have a positive impact on the share prices of the companies that are acquired, is it good news for shareholders of the company making the acquisition if they pay the wrong price?
Given the extensively documented behavioural biases that affect investors, it would hardly be rational to assume that company management teams will be immune to the same biases when investing shareholders’ capital. In fact, the same traits tend to be very much in evidence. Typically, in the three years post acquisition, the share price of the acquiring company has underperformed similar peers by the order of 5-15%.
Management thinking key
While that underperformance may not sound too scary, there are some spectacular failures; Hewlett-Packard is once more in the press after acquiring UK company Autonomy for $11bn in 2010 and subsequently having to write-off $8.8bn.
A number of theories have been put forward to explain this underperformance, which are commonly rooted in the psychology of the acquiring management team.
Often the acquiring company has had a strong period of corporate and share price performance in the period leading up to the bid. In these cases, the management teams can become over-confident in their abilities and believe those abilities will enable them to turn around the acquired company – the so-called ‘hubris hypothesis’.
Far too often the prior outperformance has been partly due to cyclical or other external factors, and the acquiring management team struggle to meet their targets for the acquisition.
Having made the decision to acquire, if the bid becomes contested, with multiple interested parties, then it becomes increasingly likely that companies will overpay. The winner (if we can call them that) will be the company making the highest bid – the dreaded ‘winner’s curse’.
Be deal-specific
Having ‘won’ the bid, an insight into the management psyche can often be gleaned by the method of funding the acquisition. If management teams, either consciously or unconsciously, perceive their own shares as expensive, and therefore a cheap source of funding relative to cash, this may encourage management to view the acquisition more optimistically and use shares as finance. Interestingly the evidence is that acquisitions financed by shares do worse than cash-financed bids.
In light of these behavioural patterns, what can investors do to protect against potential value destruction? Some simple rules may help guide us through the M&A minefield:
- Does the acquiring company have good corporate governance, with strong independent directors that can contain over enthusiastic management?
- Is the bidding process competitive, potentially leading to the dreaded winner’s curse?
- Is the acquisition financed by cash (good) or shares (bad)?
- Is the acquisition in the same industrial area? Diversifying acquisitions are often poor uses of shareholder capital.
So while we can anticipate that a recovery in M&A will help support the overall stock market, it will be important for investors to examine the merits of the individual deals very carefully.
