Why Managers Look At Acquisitions – Theory VS Reality

Why Managers Look At Acquisitions – Theory VS Reality

In the past few months, Venture Capitalist firms have received criticism on how they price startups and the repercussions that public shareholders face once these startups get publicly listed. We know that VC/PE investments or M&A activity increase when the economy is booming, and the cost of raising capital is cheap. Thus, there is a higher possibility that buyers have overpaid for these transactions. However, analysts criticize these deals at a higher interest rate environment and a slowing economy by stating that the bidders have overpaid.

There is abundant literature and studies that state that M&A deals benefit target shareholders but are disastrous for buyer shareholders because they overpay or acquire companies that do not fit their strategic rationale. In addition, some analysts argue that companies buy because managers/CEOs increase their reputation/compensation at the expense of shareholders, causing an agency conflict between the management and their shareholders.

The mismatch between theory and reality

If the empirical evidence is correct, the volume of M&A deals should decline. However, i witness the opposite; even in this slowdown, companies look to acquire to grow – the recent acquisition of Amazon and Roomba validates the same. Despite the criticism of diversification transactions, Amazon’s purchase of Roomba can generate positive returns because Amazon can fund NPV-positive projects that Roomba cannot take due to the lack of cash reserves with Roomba’s leadership staying after the closing.

Reasons Why M&A Deals Make Sense

Theorists say buyers should not enter into bidding wars in M&A as it will result in buyers paying a premium over the target’s intrinsic value and synergies. However, in reality, if more than one buyer is bidding for the target and each buyer knows that this bidding war will result in an overpayment, the efficient market theory states that the buyers should withdraw, causing a reduction in the target’s premium. 

However, in reality, we know it does not happen because either the buyers think that the target suffers from undervaluation or it can realize more synergies by acquiring it. Another plausible explanation is what happens if the buyer does not buy the target. It loses to competition, or this deal can change the underlying industry as it happened with the Google Android/Facebook Whatsapp deal. Furthermore, given that the economic environment is unique for every deal, the availability of capital and level of competition is different, and the industry would be at various stages of its maturity, the premium could be significantly additional. For example, it is almost impossible to determine how strategically a given acquisition impacted a competitor or competitors.

Thus, a buyer not resorting to M&A can harm its shareholders more than the premium it pays to acquire the target.

Importance of Post Merger Integration Strategies

An informational asymmetry exists between the buyer and the other bidders as to why a specific buyer pays a higher premium over other bidders to acquire a target company. As a result, it is challenging for analysts from outside to decipher the high payment of the premium.

Thus, we need to emphasize the integration’s success and if the buyer can realize the synergies. Analysts look at the acquirers’ track record to predict the integration’s success. This rationale is a fallacy because each transaction is different, and there is no guarantee that the acquirer’s track record will guarantee deal success. For example, Microsoft failed with its Skype acquisition, but its Linkedin deal was a success. However, we do not have literature on the management of the post-acquisition period as studies give importance to purchase price, the form of payments and deal structure over culture, and shared goals/ambitions between the target and the buyer.

Conclusion

The theory that M&A deals destroy value for buyer’s shareholders holds in theory but not in reality. If this hypothesis is correct, the volume of M&A deals would have declined. On the contrary, despite the current threat of recession, M&A deal activity has not slowed. Thus we should stop analyzing M&A deals on the purchase price and the premium paid; instead, we need to focus on the integration process and the potential pitfalls. Every M&A transaction is different, and the reason they take place is unique, a function of the firms involved, their true motivations and how the environment influences the deal maker’s decisions.