When Glaxo Wellcome announced that it was to merge with SmithKline Beecham to form a global drugs giant with a market value of £107bn, there was applause from the financial press and smiles all round. But as they clasped hands to seal the deal, Glaxo chairman Sir Richard Sykes and SKB chief operating officer Jean-Pierre Garnier must have had just a hint of concern about whether this was going to be yet another merger that looked like a strategist’s dream but ended up a shareholder’s nightmare.
Certainly, the immediate reaction from the stockmarket wasn’t encouraging, as shares in both companies retreated on news of the deal. The fall wasn’t particularly surprising: wise heads in the market know that too many mergers and acquisitions fail to deliver shareholder value, which is the one measure they’re critically interested in. Too often, as far as they’re concerned, two plus two ends up making three, instead of the hoped-for five.
Last year, a record $2.2-trillion-worth of mergers and acquisitions was done. With Glaxo-SKB, EMI-Warner Music, Vodafone-Mannesmann and Royal Bank-NatWest already in the books, it looks as though the first year of the new millennium is on target to beat that mark.
Even new research by management consultants KPMG, which shows that 83% of mergers fail to produce any benefits for shareholders, seems unlikely to dampen the enthusiasm. Nevertheless, the KPMG report ought to cause financial directors to look more closely at the rationale behind M&As.
What’s behind the current M&A frenzy? The drive towards globalisation in most industries is a key factor, argues John Kelly, head of M&A integration at KPMG. “The need to be bigger and better and be able to compete globally is driving companies to look for mergers,” he says. Kelly cites the e-commerce revolution and buoyant stock markets in many parts of the world as other reasons for the level of M&A activity.
Dr Duncan Angwin, a merger specialist at Warwick Business School, also believes that there is a range of drivers. He says: “I think there is a psychological link with stockmarkets. It’s very difficult to prove that rising stockmarkets necessarily lead to more acquisitions but, in management eyes, it may seem a better time to make acquisitions when your paper is highly valued.”
Yet while rising markets may encourage M&A activity, they don’t necessarily provide the climate in which mergers are bound to succeed. And the KPMG research spells out in stark detail just how far most mergers or acquisitions fall short of creating new shareholder value. Researchers looked at the 700 largest cross-border deals between 1996 and 1998. They found that a year after the deals were consummated, only 17% had increased shareholder value. In 30% of deals, the merger had created no noticeable difference to shareholder value, and 53% of mergers had actually destroyed some value.
What is going wrong? KPMG researchers analysed a set of distinct activities within deals. By benchmarking each company’s responses against these measures, they were able to identify those activities that have most impact on shareholder value.
KPMG found that there are two different kinds of activities – “hard keys” and “soft keys” – that create the circumstances in which a merger or acquisition is likely to meet the shareholder value measure of success. The hard keys are business activities – synergy evaluation, integration project planning and due diligence. The soft keys are people issues – selecting the management team, resolving cultural issues and communication, especially with employees.
Kelly says: “The research highlights that, to extract the full value from the deal, acquirers must find the right balance between activities focused on financial performance and those related to the people and cultural aspects. In effect, the hard keys and soft keys together unlock the maximum potential of the enlarged company.”
The problem is, argues Kelly, that too often companies concentrate on the mechanics of the deal – the hard keys – to extract value from the acquisition. “No matter how intensive the planning, how innovative the financing or watertight the contract, research shows it is the soft issues, such as people, that are key in achieving the realisation of value.”
The research seems to underline this point in a dramatic way. Of the mergers and acquisitions studied, less that 10% had made a priority of the three soft keys during the integration project planning stage. But all of those which did so increased shareholder value. Indeed, the research suggests that a kind of success multiplier kicks in. The more of both the hard and soft keys a company gets right, the higher the chances that its merger or acquisition will end up by increasing shareholder value.
But while the KPMG research is useful in pinpointing some important factors that do influence the success of mergers, Angwin wonders whether measuring shareholder value a year after the deal provides enough time for all the synergies to mature. “In some deals, particularly complex ones such as those in the pharmaceuticals industry, I think you could make a strong case for saying it is going to take many years to reap the rewards. For example, combining an R&D team – I don’t see that happening in a year.”
Angwin points out that there is, in any event, a mismatch between what stockholders and top management want from a merger. For example, while stockholders want increased shareholder value, managers may be looking for the larger remuneration packages that running a mega-company brings.
He also points out that when it comes to mergers, there is a real difference between “creating” and “capturing” value. For example, a bargain hunter might buy an undervalued company and capture the value of its assets, but that doesn’t mean that the merger has created new value. Angwin argues that every acquisition or merger ought to be about enhancing rather than undermining competitive advantage. “So you need to be clear on what it is and how you achieve it,” he says.
One of the dangers in the current M&A environment is that many acquirers are paying high premiums for the companies they are buying. This is stimulated by the fact that many acquisitions take place in an auction environment – for example, Bank or Scotland and Royal Bank of Scotland bidding for NatWest. Kelly points out that, back in the nineties, it was possible for bidders to keep some of the potential synergy benefits of the deal up their sleeves as a way financing any premium that was paid. When auctions bid up prices, that’s much more difficult to do.
What’s worse is that the auction environment gives managers much less time – and sometimes less information – with which to make a judgement about the synergies that a deal they’re interested in could release.
Kelly says: “We found the work you do before a deal is really about assessing the premium element of the synergies. That pays dividends because it is more important to do the right deal, than just to do a deal.”
Andrew Campbell, director of Ashridge Strategic Management Centre, agrees that the equation between the premium paid and the synergies that can be released is the key to determining whether a deal can be a success.
Campbell, who has done work on synergies, believes it’s useful for FDs to have a clear view of the different kinds of synergy that might be used to create value.
He sees three kinds of synergies where it’s easier to harvest value and three where it’s more difficult. The “easier” list is headed by what Campbell calls “know-how synergies”. For example, an organisation that takes over a company may acquire know-how in a management area where it was previously weak. This could be anything from learning how to run just-in-time manufacturing to what products sell best in an unfamiliar market.
Next on Campbell’s list come tangible cost synergies, which are often some of the most important benefits managers expect to achieve after a merger. These can come about by, for example, merging branch networks, as in the case of banks and building societies, or merging R&D operations as in the case of pharmaceutical or aerospace companies.
Bargaining power synergies also often look attractive when seeking to justify a potential deal. “By putting organisations together, you can gain more leverage with certain stakeholders, including bankers and shareholders – for example, in getting lower costs of capital.” Other key stakeholder groups where there may be bargaining power synergies include suppliers and customers.
Campbell suggests that it’s more difficult to harvest benefits from the next three synergies on his list. For example, vertical integration synergies – such as costs reduction by inventory reductions in a supply chain – may look attractive. But Campbell warns that sometimes the management skills required to run businesses in other parts of the supply chain are fundamentally different to those that the buying company has. As a result, it’s more difficult than expected to make savings.
There can also be problems gaining benefits from strategic coordination synergies. For example, it may seem logical to merge with a competitor in order to reduce competition in key markets. Unfortunately, other competitors won’t necessarily see it that way. Worse, such a move can mean that both parts of the merged organisation lose some competitive edge in what is, initially, a less keenly fought-over market. This provides just the circumstances in which a more nimble third party may be able to move in.
Finally, new business creation synergies are not as easy to deliver as they may appear, argues Campbell. For example, it may look sensible to put together an Internet business like AOL and a content business like Time Warner. “But you are usually putting together very different businesses under one umbrella and trying to create a new business that is even more different from both of them – and the soup is liable to curdle,” he says.
For Campbell, the key pre-deal work must include an assessment of how big all the supposed synergies that the deal creates will actually be.
“The rule of thumb is that unless they are more than 20%, you’re probably not even off the starting block,” he says. “That’s because you’ll be paying a premium of at least 20%. If there is a premium of 50%, then you had better be confident that they benefits are at least enough to cover the premium.”
Campbell suggests that those businesses which make a consistent success of mergers are those which become knowledgeable about the kind of synergies they can most profitably farm. “They look for targets that have that synergy potential within them and they get experience about what would be a reasonable price to pay – and they can repeat that formula many times.”
But it’s possible that the M&A landscape is changing – making those companies which had been successful at taking over and integrating smaller companies more vulnerable. Kelly says: “The market is no longer interested in small acquisitions. So the companies that have bought 10 or 15 companies a year are now being pressurised to spend the same amount of money in a single transaction.”
However, because these companies’ experience is in integrating small businesses there’s a danger they’ll be left stranded culturally with the problems of managing the post-merger integration of a larger takeover.
And that’s not all. “We’ve found recently that businesses that are renowned for being successful at small acquisitions are, themselves, targets because their growth hasn’t been sustained,” warns Kelly.
Stuck between the rock of being pressured by the market to make a large and risky acquisition and the hard place of being taken over by a hated rival is not an attractive position for many companies. But the reality is that M&A fever looks unlikely to abate in the immediate future. So, if they really want two plus two to make five, most companies need to give fresh thought to that most strategic issue of all: what’s our future going to be?
WHAT HAPPENS WHEN IT ALL GOES WRONG
Some merger horror stories are described by Dr Duncan Angwin in Implementing Successful Post-Acquisition Management*, which shows managers what to do after the deal is done. Angwin says there are three main reasons why an acquisition turns out to be not what the purchasers expected.
First, there may be unpleasant surprises. For example, after Ferranti’s acquisition of International Signal Controls, it was found that ISG’s claims about substantial contracts in the offing were never checked. Result: a massive hole in Ferranti’s balance sheet.
British & Commonwealth caught not just a cold but a fatal dose of financial flu when it acquired Atlantic Computers for £408m. Afterwards, so many nasty liabilities emerged that British & Commonwealth went into administration.
Another kind of unpleasant surprise is when the people from two businesses merge into one and find they don’t like each other and there’s a culture clash. This happened when Merrill Lynch acquired Smith NewCourt – with high-profile departures on both sides.
Indeed, across the banking sector, mergers don’t seem to be very effective at boosting profitability – Royal Bank of Scotland, take note. The Bank for International Settlements has reported that banking profitability in 12 countries has fallen despite a recent wave of mergers.
The second way that a takeover can go wrong is when the buyer doesn’t understand the acquired company, says Angwin. He cites the case of a utility that acquired a successful engineering company that made filters. “During the negotiations it was clear to the top management of the target company that the utility saw them as part of a vertical diversification strategy.
Post-acquisition, it rapidly became clear that this was more or less a fiction, as the acquired company’s sales continued to be to other players in the industry rather than the new parent, and there was little dialogue between themselves and head office.”
Finally, difficulties in achieving synergies can also drive a corporate marriage close to divorce. For example, one of the most commonly sought synergies – cutting costs – is not always delivered. Angwin quotes evidence from the US that merged banks are slower to cut costs than competitors that continue to plough a lonely furrow.
* Financial Times Prentice Hall, £95.00.
THE IMPACT OF CROSS-BORDER DEALS
International mergers add a new level of problems that can derail deals. KPMG’s research* found that deals between UK and US firms are 40% more likely than average to be successful, while deals between UK and European companies are 19% more likely to be successful. But deals between US and European countries are 11% less likely to be successful than the average.
John Kelly says: “Our interpretation of these results is that businesses in the UK and US have historically conducted more cross-border deals and, therefore, have the advantage of greater experience. Additionally, the UK and US have an increasingly strict regulatory code regarding merger benefits, which may be having an effect on overall success rates. Or it may simply be a question of mother tongue. If you do not speak the same language, while you can communicate, subtle nuances may be missed or, indeed, misinterpreted, and this can severely derail the sensitive integration process.”
Kelly adds: “Our survey suggests that companies entering into cross-border deals that link companies of disparate cultures or languages need to pay particular attention to the problems of cultural integration. They must focus effort on communication programmes and should look at reward systems to reinforce change management programmes.
“It also seems that experience pays. Countries that have seen extensive consolidation over the past 30 years perform significantly better than the relative newcomers.”
* Unlocking shareholder value: the keys to success, KPMG.