Mergers & Acquisitions: The Good, the Bad, and the Ugly (A Reality Check for Equity Analysts)
Avoiding common pitfalls: how to spot red flags in M&A deals
During the late 1990s, Marvel Entertainment was struggling with bankruptcy. The company, once thriving through its comic book sales and character licensing deals, faced a drastically changing landscape.
Nevertheless, after the bankruptcy proceedings, it managed to turn itself around and ended up being acquired by Disney for $4 billion in 2009, a move initially seen as risky given Marvel's past financial troubles. However, this acquisition turned out to be incredibly successful, revitalizing Disney's presence in the superhero genre and leading to blockbuster hits like "The Avengers."
Could the success of the acquisition have been predicted beforehand? What telltale signs can an analyst use to forecast the success or failure of an M&A strategy?
Below, I share an approach on how to evaluate M&A strategy, assess past acquisitions, and calibrate expectations for the future.
Let’s begin.
Growth vs. Greed: Which Are The True Drivers of M&A?
The first thing I aim to understand when looking at a company that grows with acquisitions, is the management team's thought process, their M&A strategy, and, most importantly, their motivations when seeking M&A candidates.
As always, in a complex world, M&A motivations are often a mixed bag, with a combination of factors driving the decision. So, below I attempt an imperfect taxonomy.
Financial Motivations:
Synergy Creation: Oh my… more on this below. But basically refers to the belief that combining two companies will result in greater efficiency and profitability than the sum of their individual parts. Take the Exxon and Mobil Merger in 1999: the merger led to significant cost savings, increased efficiency, and strengthened the combined company's position in the oil and gas industry. This is not always the case though.
Increased Market Share: Eliminating competitors or consolidating market power to gain pricing power and profitability. AB InBev acquisition of SABMiller in 2016 created the world's largest brewer, solidifying their dominant market position.
Economies of Scale: Lowering per-unit costs by increasing production volume and spreading fixed costs over a larger base.
Diversification: Reducing risk by spreading investments across different industries or markets. You could say Berkshire Hathaway's acquisitions contributed to build a diversified portfolio that has proven resilient to economic downturns and continues to generate strong returns.
Tax Benefits: Leveraging losses or favorable tax structures of the acquired company.
Financial Engineering: Improving financial ratios or gaining access to cheaper capital through M&A.
Undervalued Assets: Acquiring a company believed to be undervalued by the market.
Strategic Motivations:
Market Expansion: Entering new geographic markets or customer segments. Facebook's acquisition of WhatsApp in 2014 allowed Facebook to significantly expand its user base as WhatsApp became a major player in international messaging.
Vertical Integration: Acquiring suppliers or distributors to control the supply chain.
Horizontal Integration: Acquiring competitors to consolidate market position.
Product/Service Diversification: Expanding the product or service portfolio to reduce reliance on a single offering.
Access to New Technologies or Capabilities: Acquiring a company to gain access to innovative technology, intellectual property, or specialized skills. There are many examples in the tech space. Facebook acquisition of Oculus or Microsoft's acquisition of LinkedIn where data and network have been integrated into Microsoft's products.
Defensive Strategy: Protecting against a hostile takeover or fending off competition.
Brand Enhancement: Acquiring a company with a strong brand reputation to elevate the acquirer's brand image. An example of this could be LVMH's acquisition of Tiffany & Co. in 2021 where LVMH aims to leverage Tiffany's brand to strengthen its position in the luxury jewelry market.
Managerial Motivations:
Definitely not the best motivations to initiate an M&A process.
Personal Incentives: Executive compensation is often tied to company size or growth targets, incentivizing M&A deals that may not be in the best long-term interest of the company or its shareholders.
Empire Building: The desire of executives to lead a larger, more prestigious company can lead to ill-advised acquisitions driven more by ego than sound business strategy.
Other Motivations:
Regulatory Requirements: M&A may be necessary to comply with changing regulations or antitrust laws.
Distressed Sale: Acquiring a struggling company at a discounted price.
Succession Planning: Acquiring a company to secure a successor for the CEO or management team.
So which are the type of acquisitions that have the best odds of generating value for the shareholders? Let’s see.
The Disciplined Acquirer: Small Bites, Big Rewards in the M&A Game
In general, when investing in a company that grows through acquisitions, I favor those that make numerous small, frequent acquisitions that are clearly related to the acquirer's core business—and there are famous examples of companies doing this successfully, Constellation Software being one.
As always, it comes down to tilting the odds in your favor as an investor and this approach offers various advantages:
Risk Mitigation: Smaller deals inherently carry less risk than large, transformative ones.
Smoother Integration: Cultural alignment is easier to achieve with smaller companies in the same industry.
Greater Opportunity: More frequent acquisitions increase the chances of finding great companies at fair valuations.
Enhanced Capabilities: Smaller companies can often bring specialized skills or technologies to the table.
As I discussed earlier, M&A motivations can vary, but if I see a company implementing this strategy (smaller, frequent acquisitions within their core business), I believe it significantly increases the odds of achieving a satisfactory result.
To use a sports analogy, I prefer CEOs who consistently hit singles and doubles rather than those swinging for the fences with infrequent, high-risk acquisitions.
This strategy of consolidating many small companies within the same industry is known as a "roll-up strategy." When executed well, roll-ups can be highly successful due to:
Cost Reduction: Eliminating redundancies and streamlining operations.
Increased Buying Power: Negotiating better deals with suppliers due to greater volume.
Reduced Debt: Consolidating debt can lead to lower interest rates.
Marketing Leverage: Utilizing a single, umbrella brand for greater impact.
The key to evaluating a roll-up strategy lies in making sure that the acquired companies operate within the same industry as the acquirer, ensuring the acquirer possesses the necessary expertise to successfully integrate and manage the new entities.
If you want to dig deeper in this strategy, here’s a great piece by Scott Management on Serial Acquirers written on January 2020.
Ok, let’s talk about synergies, that little word that appears in every M&A press release.
From Buzzword to Bottom Line: How to Evaluate Synergies?
Management talk about synergies when the value created from the combination of two companies is greater than the sum of their parts. Yes, the typical 1 + 1 = 3.
Now, I’d say there are three types of synergies:
Cost Synergies: These are the most common and tangible form of synergy, and probably the most credible to accomplish when management mention them. They result from reducing costs through:
Eliminating redundancies: For example, consolidating departments, reducing headcount, or closing duplicate facilities.
Increased bargaining power: With larger scale, the combined company can negotiate better deals with suppliers.
Operational efficiencies: Optimizing processes, supply chains, and technology to reduce costs.
Revenue Synergies: These are more difficult to predict and quantify, but they represent the potential for increased sales or revenues. These can be achieved through:
Cross-selling: Offering each company's products or services to the other's customer base.
Market expansion: Gaining access to new markets or customer segments.
Increased pricing power: Combining market share can give the company greater leverage to raise prices.
Product innovation: Leveraging the combined resources and expertise to develop new or improved products.
Financial Synergies: I guess you could call them financial synergies but basically you end up having cost savings in debt and taxes.
Lower cost of capital: Accessing debt or equity financing at a lower cost due to the combined company's stronger financial profile.
Tax benefits: Utilizing losses or favorable tax structures of one company to reduce the tax burden of the combined entity.
In many cases, this “buzzword” is used to mask overpaying for the target company. If the acquired company operates in a different industry or serves unrelated customers, the chances of realizing these promised synergies are…not so great.
A recurring theme in this newsletter is my guiding principle as an investor: always tilt the odds in my favor. So, when evaluating synergies, I strive to ensure they're the ones with the highest base-case probability of success.
Now, we've discussed strategy and synergy, but what specific aspects of past acquisitions can we analyze to assess management's competence and decision-making?
Evaluating Previous Mergers & Acquisitions
Companies that grow through mergers or acquisitions often face skepticism. Why? Because a significant number fail to deliver on their promises. But what are the most common causes behind these failures? Generally speaking, these include:
Overpaying for the acquired company.
The acquired company's underlying weaknesses or lack of strategic fit.
Cultural clashes leading to talent loss.
In short, numerous factors can derail an acquisition. To really analyze past transactions, let’s break down the analysis into seven distinct areas:
1) Relationship with the company's main business
As I've emphasized throughout this article, a key factor in predicting the success of an acquisition is determining whether the companies involved operate within the same sector or industry.
2) Understanding of the management team
Expanding on the previous point, when a company acquires another within the same industry, it's far more likely that the management team possesses a deep understanding of the target's business, significantly reducing the risk of a misguided acquisition.
3) Client retention
Customer retention a great indicator of acquisition success. If a significant portion of customers remain loyal two to three years after the merger, it strongly suggests that the acquisition has been beneficial and that the combined entity is effectively meeting customer needs.
4) Talent retention
The same goes for talent. Evaluate whether key employees remain with the company years after the transaction has been completed.
This factor is of vital importance, especially in operations related to the software industry, where many times what is acquired is the team of developers, who may have special skills required by the acquiring company.
It is important to look for signs that indicate that the management team cares about the talent and culture of the acquired company.
5) Disciplined past acquisitions avoiding overpayment risk
There are several reasons why a company may end up overpaying when acquiring another company. Above all, this is usually related to the inability of the management team to determine the value of what is being acquired, often blinded by the enthusiasm of making new acquisitions.
Determining whether the price paid was correct can take at least 3 to 5 years (a period of time in which we can clearly observe the results of the acquisition). Therefore, it is important to try to look for acquisitions made by management in the past and thus evaluate whether the decision was wise or not.
In general there are 5 situations that can lead to overpayment:
Bidding war between buyers: If there is a price war clearly the final price will be high.
Threat of a competitor gaining market share: If the objective of the acquisition is to gain market share to defend itself against a potential competitor, it is likely that a high price will be paid.
Operation size: In relatively large transactions for the acquiring company where the adjectives "transformational" and "game-changing" are mentioned, we may be facing a high risk of failure.
Healthy outlook of the acquired business: Good companies will attract high offers.
Market situation: Finally, if the market is in an upward trend, high prices will clearly be paid.
A more intangible factor to analyze is the management team's discipline in acquisition negotiations. Have they demonstrated a willingness to walk away from deals in the past when the price exceeded their predetermined limit?
One way to find tangible evidence of such discipline is to review transcripts of previous quarterly earnings calls. Look for instances where the CEO mentions backing out of potential acquisitions at the last minute due to even minor disagreements on price. This indicates a commitment to financial prudence and avoiding overpaying for assets.
6) Price paid
Although this information is often difficult to obtain, it is one of the fundamental variables to determine the result of transactions that occurred in the past.
If the multiple at which the transaction was made is reported, it will typically be EV/EBIT, EV/EBITDA, P/E or P/FCF. Having any of these multiples will help me determine what the management team's perspectives are regarding the future of the business.
7) Financing of the operation
Finally, the method of financing the acquisition falls into four main categories: all cash (the most conservative), all debt, all equity in the acquiring company, or a combination of these three.
All-cash transactions are the most conservative as they utilize existing cash reserves on the balance sheet, avoiding additional financial leverage.
Debt financing, on the other hand, carries inherent risk. Taking on excessive debt can jeopardize a company's financial stability and increase the likelihood of default. Therefore, it's crucial to assess coverage ratios to ensure the company can comfortably handle debt repayment obligations.
Lastly, a company may opt for an all-equity deal, using its own shares to acquire another business. In this scenario, it's essential to determine whether the acquiring company's shares are overvalued or undervalued, as this will impact the deal's fairness and potential dilution for existing shareholders.
Conclusion
In conclusion, mergers and acquisitions are a powerful and dynamic growth tool, capable of accelerating sales and strengthening a company's position in the market.
However, they also pose a significant risk of value destruction if not managed properly.
Therefore, it is vital to carefully evaluate a company's M&A strategy, analyze the success of past acquisitions, and form a clear idea of future expectations through this strategy.
Hope this was helpful. Below, I share an investment checklist to aid in evaluating such strategies.
All the best,
Polymath Investor
M&A Investment Checklist
What is the overall mergers and acquisitions (M&A) strategy of the company? - It is important to understand a company's overall M&A strategy to evaluate whether it aligns with long-term growth objectives. A solid strategy can help drive growth, improve operational efficiency, and increase company competitiveness. That is why it is key to "get into the shoes" of the management team to understand the motivation for their decisions.
What statements has the management team made about the motivations and objectives of the acquisitions? - Public statements from the management team can provide valuable insight into their motivations and objectives. Statements that are in line with the company's M&A strategy may indicate a commitment to the strategy.
Do they mention the word "synergy" in the justification of the purchasing decision? - Be very careful in these situations and make sure that if they promise both increased sales and reduced costs, that the strategy makes sense and has a high probability of being carried out.
How is the M&A strategy integrated into the company's global corporate strategy? - The M&A strategy must be in harmony with the company's global strategy. If the acquisition is made in the same industry in which the company operates, there is a much greater chance of success.
What is the company's M&A track record over the last 5-10 years? - A company's M&A history can provide valuable insight into its ability to successfully execute acquisitions and mergers. Past successful transactions may indicate effective management and an ability to achieve synergies. Keep in mind that to determine if an acquisition was successful, we may have to wait 3 to 5 years to see how the business develops.
How has M&A affected the company's profitability? - Understanding how acquisitions and mergers have impacted the company's profitability can help you evaluate the effectiveness of your strategy. A positive impact on profitability may indicate that acquisitions and mergers have added value, again, within 3 to 5 years.
How does the company evaluate M&A opportunities? - The criteria a company uses to evaluate M&A opportunities can reveal a lot about its approach and priorities. This understanding can provide valuable insight into future M&A decisions. Many times there is a hurdle rate, a minimum rate of return that is required of any company that is an acquisition target.
How does the company finance its acquisitions? - The way a company finances its acquisitions can have a significant impact on its long-term financial health. Companies that rely too much on debt may be at risk of financial problems in the future.
How does the company integrate new acquisitions into its existing operations? - A company's ability to successfully integrate new acquisitions into its existing operations is a crucial factor for M&A success. Lack of an effective integration strategy can lead to disruption and acquisition failure.
How does the company measure the success of its acquisitions? - The metrics a company uses to measure the success of its acquisitions can provide valuable insight into its approach and expectations. A set of clear and meaningful metrics can indicate effective and realistic management. Generally we should look at the management team's communications to see what they are looking at.
How has the M&A affected the company's market share? - Mergers and acquisitions can be an effective way to increase market share. If past acquisitions have resulted in an increase in market share, this may indicate an effective M&A strategy.
How does the company manage the risks associated with mergers and acquisitions? - Effective risk management is key in the M&A process. Companies must have robust strategies to mitigate the financial, operational and reputational risks associated with acquisitions.
How has M&A affected the diversification of the company's product/service portfolio? - Diversification is an important strategy to manage risk. Acquisitions that increase diversification can help protect the company against volatility in certain markets or sectors.
Have there been any M&A failures in the past and how has the company learned from these failures? - Previous failures can provide valuable lessons for future acquisitions.
How is the M&A strategy related to the company's competitive position? - Acquisitions can be used to strengthen a company's competitive position.
How does the company communicate with shareholders about its M&A strategy? - A company that clearly and regularly communicates its M&A plans can build trust and minimize uncertainty.
How have employee relations been affected by mergers and acquisitions? - Mergers and acquisitions can have a significant impact on employee morale and satisfaction. Companies that effectively manage this aspect can minimize staff turnover and maintain a high level of productivity. Analyze the talent retention rate years after the acquisition is completed.
What percentage of past acquisitions have been profitable? - The profitability of past acquisitions can indicate the company's effectiveness in selecting and managing acquisitions. A high percentage of profitable acquisitions could suggest that the company has a good due diligence process and effective acquisition management.
How long has it taken, on average, for past acquisitions to become profitable? - The time it takes for an acquisition to become profitable can be an indicator of the company's effectiveness in integrating and maximizing the value of acquisitions. A shorter time period may indicate greater efficiency and management ability.
How have past acquisitions affected the company's debt-to-equity ratio? - Acquisitions are often financed with debt, which can increase the company's debt-to-equity ratio. A significant increase in this ratio could indicate higher financial risk.
How much has the company spent on acquisitions compared to its free cash flow in recent years? - Spending more on acquisitions than the company generates in free cash flow can be a warning sign. This may indicate over-reliance on debt or possible over-expansion.
How have the acquisitions affected the company's profit margins? - Acquisitions can have a significant impact on the company's profit margins. If profit margins have decreased after acquisitions, this may indicate that the acquisitions have not been effective.
What has been the impact of the acquisitions on the company's EBITDA? - EBITDA can give an idea of a company's operating profitability. If the acquisitions have led to an increase in EBITDA, this may indicate that they have been profitable.
How do the motivations of the management team align with the company's M&A strategy? - It is important that the motivations of the management team are in line with the company's M&A strategy. A mismatch may indicate a lack of commitment or an inconsistent strategic direction. It is key to review the management team's compensation plan in the company's annual reports. Hence the next question.
Are management team bonuses and compensation linked to M&A success? - Linking management team compensation to M&A success can help ensure they are motivated to make acquisitions a success.
Does the management team have experience in managing mergers and acquisitions? - M&A experience can be a key indicator of a company's ability to successfully manage acquisitions. A management team with strong M&A experience may have a better understanding of how to identify, execute and manage acquisitions effectively.
How long has the current management team been in place and how many acquisitions have they overseen? - A management team that has been in place for a long period and has overseen multiple acquisitions may have a better understanding of how to effectively manage M&A.
How transparent has the management team been about the goals and results of the acquisitions? - Transparency is a key aspect of effective management. A management team that is transparent about the objectives and results of acquisitions can build trust and credibility.
Factors that indicate a possible failure or overpayment of the merger or acquisition operation:
The acquiring company uses its own undervalued shares to make the acquisition.
There is a price war and an auction dynamic occurs between the different buyers.
The management team uses a lot of debt to make the acquisition.
Factors that indicate a possible success of the merger or acquisition operation:
The management team has a track record of successful transactions in the past.
The acquisition is within the industry in which the purchasing company's main business is carried out.
The management team deeply understands the business they are buying.
Key employees and customers remain with the purchased company years after the acquisition is made.
The management team uses its own overvalued shares or cash to carry out the transaction.
Sources
Scott Management, LLC. (2016-2021). Goals and Incentives, Competitive Advantage, Search Strategy, Management's Increasing Importance Over Time, Serial Acquirers, Low-End Disruptors. Retrieved from
https://www.scottmanagement.com/
Shearn, Michael. The Investment Checklist. John Wiley & Sons, 2011.
Bruner, R. F. (2004). Applied Mergers and Acquisitions. John Wiley & Sons.
DePamphilis, D. M. (2019). Mergers, Acquisitions, and Other Restructuring Activities. Academic Press.
Sirower, M., & Weirens, J. (2022, May 20). What makes M&A so challenging? CFO Journal. The Wall Street Journal.
Knowledge at Wharton Staff. (2005, March 30). Why Do So Many Mergers Fail? Knowledge at Wharton. https://knowledge.wharton.upenn.edu/article/why-do-so-many-mergers-fail/