Are high acquisition/takeover premiums justified in current M&A environment?

Introduction

  1. Favorable market conditions like low interest rates and booming stock markets along with record volumes of cash reserves with corporate firms and dry powder with Private Equity firms have increased competition in the current M&A environment. With record levels of cash available and few quality target companies in the market, there is an intense bidding happening within the acquirers to buy target companies.This competition is more intense in growing sectors like Technology, Media and Healthcare.Acquirers are paying record premiums to targets that are not even profitable.

So the question is?
Is the high premium/valuation multiple justified?

  • Recent analysis of many deals with high takeover premiums shows that high premiums were not due to the high intrinsic value of the target company.Generally a high premium is paid due to the potential for high synergies and to gain high control over the target entity post acquisition.
  • Generally when arriving at an acquisition premium, the buyer values the standalone target company based on its future projected cashflows to arrive at the standalone enterprise value.Then the buyer values the combined entity taking into account, the cost and revenue synergies that the buyer can derive post the acquisition.The acquisition premium would fall between the standalone enterprise value of the target and combine value of the entity including synergies.The takeover premium increases when there are more than one bidder for the deal.
  • Most of the high premiums are paid to those deals where the acquirer wants to leverage the target company to enter into a new market or build a new capability.Inspite of this rationale, the high takeover premium still does not justify the intrinsic value of the target.
  • This is because the reason for high premium is not deal specific.Many acquirers are ready to pay high premium to gain a first mover advantage in a new technology/market over its competitors or simply prevent the competitors to acquire the target company.
  • Microsoft acquisition of LinkedIn is a classic example where Microsoft paid a 50% premium to LinkedIn share price to arrive at $198/ share to close the deal.This is despite the fact that LinkedIn revenues were declining but Microsoft rationale was to create additional product offerings leveraging LinkedIn social network.In addition, Microsoft also wanted to prevent Salesforce, its rival in CRM which was equally interested in buying LinkedIn.This intense competition increased the overall deal value.
  • One of the biggest reasons why many acquisitions fail is because the buyer ends up overpaying for the transaction with other two reasons being, failure in able to integrate the target to achieve value and unable to prevent attrition in target senior leadership due to the cultural issues.
  • A leading metric that would indicate if the acquisition had created shareholder value is when the ROIC – Return on Invested capital for the acquisition is higher that WACC – Weighted Average Cost of Capital.When we take this metric and apply to all recent M&A transactions announced lately, then most of the acquirers have overpaid for the transaction.

Are Acquisitions really important to increase Shareholder value?

  1. There is a lot of argument whether M&A is really needed to improve market share and increase shareholder value.Cant these be achieved through organic growth strategy?
  2. There are few things that is needed to be done to increase market share.These are:

Introduce a New Product/Service offering

  • Apple had increased its revenues from $5B to $200B from 2010-17 because of the introduction of iphone and iPad.These new products had catapulted the rise in Apple fortunes.Introducing a new product and gaining wide adoption is really a lottery game and not everyone can have success.For instance Microsoft or Google tried to replicate this offering but were failures.

Expand into New Market or drive new user adoption

  • Another way to increase the market share would be to diversify the product and market offering either by targeting new market or providing new service to an existing customer.

Move into a high growing market

  • Companies need to provide services or products that are in demand.Hence they have to operate only in high growing markets.If the service offerings provided by the companies are no longer in demand, then they need to move to higher value offerings.For instance Apple revenues increased in 2014 even after their market share declined because smartphones market as a whole was growing.Companies that try to increase market share in a declining market has to reduce its price to increase that share which may impact the margins.Hence the prudent decision for companies whose offerings are no longer relevant would be to move to higher value service offering.

Doing Acquisitions to increase market share

  • If none of the above steps works to increase their market share, then the companies need to look to acquisitions.The reason why M&A activity is so high is because the companies are not able to achieve organic growth and hence they are looking at M&A to buy growth.Most of the existing offerings provided by the companies are no longer relevant and time taken for them to build these organic capabilities will be too long by which they will lose market share.Hence most M&A happen because they offer a quick route to achieve growth and also prevent competitors to gain additional market share.
  • These activities happen at the expense of high risk and high cost for the acquirers.At the moment, high cost is taken off by the current favorable market environment but high risk of able to achieve value post acquisitions is still there.There is no guarantee that these high acquisition premium would help achieve company objectives of increasing market share.

Do all M&A deals have high takeover premium?

  1. The takeover premium for a deal depends on the acquisition strategy.
  2. If the acquisition is happening within the same industry or if the target company future growth projection is either stagnant or modest, then the premium paid is generally low.These acquisitions generally leverage the target business model for additional revenues or high cost savings.These acquisitions generally result in a low gain in market share for acquirers.
  3. Acquisitions which redefine the acquirer business model post acquisition generally have high takeover premium.For instance an IT company that generates revenues by outsourcing would generally pay a higher premium to acquire a SaaS company because this acquisition will give it recurring high quality revenues at lower cost of sales operations.

Conclusion

  1. Most of the recent M&A deals have been closed at high acquisition premiums resulting in a high purchase price for the deal.Such deals are more rampant in digital and technology sector.Questions needs to be asked if these high premiums can be justified and whether this will increase shareholder value.
  2. One of the main reasons why acquisitions fail is because the acquirer ends up overpaying for the transaction.This puts an additional pressure on the integration teams to successfully execute the integration to derive the synergies benefits in order to achieve the value.
  3. A right metric to assess if the acquirer has not overpaid for the acquisition is when the return on invested capital – ROIC from the acquisition is higher than the WACC – Weighted average cost of capital.In this condition, the acquisition will increase shareholder value.Going to be the above metric, most of the acquisitions closed recently are overpaid.


Leave a Reply

Open chat
Powered by