Tag Archive: acquisitions

Avoid Deal Failure: Ask These Tough Questions Before Any Acquisition

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Justin Johnson

Justin Johnson

It is easy to get caught up in the excitement of a deal—the unvarnished optimism of the corporate development team, the bullish spreadsheets from the bankers, the juicy steaks at the closing dinner. The numbers, however, don’t lie. It is estimated that at least half of all merger and acquisition (M&A) deals ultimately fail, destroying shareholder value for the acquirer instead of increasing it. A disciplined valuation analysis—ideally conducted with minimal involvement of the deal team and bankers—can help board members avoid unsuitable matches and support deals that are a good long-term fit.

A Synergistic Match

Assume your company has identified an acquisition target operating in your business and serving similar customers. Cost savings from the combination are expected as the result of an overlapping distribution network and because redundant production and administrative staff can be eliminated. This is a classic synergistic deal, where the acquirer boosts overall profit by adding the target’s revenue to its topline while eliminating many costs associated with achieving that revenue.

The first step in evaluating such a transaction is establishing the market value of the target without regard to buyer-specific synergies. While acquirers are usually most interested in the valuation of the combined company, there are good reasons for first establishing a baseline market valuation of the target on a stand-alone basis:

  • It gives the buyer insight on a valuation the target might expect to receive in the deal.
  • It provides a reference point the buyer can use to evaluate how much synergy it brings to the table.

Determining Baseline Value                             

There are several common approaches for deriving the market value of an acquisition target, and an acquirer should undertake as many of them as possible to establish a baseline valuation matrix. The two common techniques for publicly traded entities are straightforward. They entail analyzing the target’s historical stock price and the premium at which its stock trades after the deal is announced. For our purpose, assume the target is not public and review the four valuation approaches commonly applied to private companies.

  1. One of the most common techniques is by referencing the trading multiples of comparable publicly-traded companies. Care is required in the selection of comparable public companies to ensure similarity of operations, size, and growth prospects with the target company.
  2. Another common method is to consider recent M&A deal multiples for similar companies. For this approach, make sure to distinguish between financial sponsor deals and strategic deals, as strategic deals frequently pay higher multiples due to acquirer-specific synergies. Value indications from these approaches entail applying observed market multiples to the target’s standalone earnings, typically before interest, tax, depreciation, and amortization (EBITDA).
  3. If a long-term forecast is available for the target, financial advisors sometimes use a discounted cash flow (DCF) analysis. It should be stressed, however, that this analysis is only as accurate as the underlying forecast, which may be suspect. For this reason, a DCF analysis often is underweighted—and sometimes omitted altogether—from a valuation exercise. Additionally, a “haircut” may be applied to the forecast itself before it is put into the model.
  4. Finally, if the target is likely to attract financial buyers, advisors may employ a leveraged buyout (LBO) analysis. This approach values the target by establishing what a financial buyer would be willing to pay for the company under the financing structure it might be expected to use—often a combination of debt and equity. If a company is underperforming its peers, the LBO model may also include some assumptions about reorganization and/or add-on acquisitions.

Once as many of the preceding approaches as practicable have been performed, financial advisors triangulate the various pricing indications to establish a baseline market valuation range for the target.

Establishing Pro Forma Value

The next step is assessing the value of the acquirer after acquisition. This analysis is different than the market valuation analysis because it factors in synergies to show the value of the acquisition to that specific buyer. A word of caution: Board members should be wary of synergy projections from bankers or corporate development personnel who are emotionally or financially invested in the deal. Considering the stakes, engaging an outside advisor not connected to the prospective transaction to provide an independent valuation and estimate the potential synergies can be a sensible course of action.

No matter who is performing the pro forma analysis, a number of factors should be evaluated: the amount of expected synergies, the costs associated with realizing those synergies, the amount and type of purchase consideration, and the trading multiples for the acquirer’s stock.

Even for a disinterested third party, it is challenging to estimate synergies with accuracy, so it is prudent to perform a sensitivity analysis of the transaction’s impact on the acquirer’s share price. This is best revealed in a sensitivity table that varies both the amount of assumed synergies and the purchase consideration. Layering in an additional variable to the sensitivity analysis, the estimated one-time integration costs incurred to achieve synergies can further enhance precision. These costs can be just as difficult to project as synergies, so a range of estimates is appropriate.

The resulting sensitivity table can provide board members a powerful visual tool to understand how much it makes sense to pay at varying levels of synergy and costs. If the resulting analysis shows that a deal increases shareholder value—even if actual synergies realized are at the low end of expectations and one-time costs incurred to realize those synergies are at the high end—the deal likely will turn out well from the acquirer’s standpoint. An even better deal is one that increases shareholder value if synergies are below the low end of the estimated range and integration costs are above the high end.

Conversely, deals that are only accretive at or near the most favorable ends of the two ranges are likely to destroy shareholder value.

Other Impacts on Value

What about the impact of the type of purchase consideration on value? An acquisition can be financed with available cash, new debt, stock, or some combination of these. Debt financing will create a drag on future earnings in the form of interest expense, another cost of realizing synergies that must be considered. If acceptable to the seller, using stock may be advantageous to the buyer.

A final factor to consider is the valuation multiple of the acquirer. If historically it has been somewhat volatile, it is a good idea to run a sensitivity analysis on the pro forma value of the stock, assuming a range of valuation multiples for the acquirer consistent with its recent trading history. The lower the valuation multiple, the lower the increase in value from transaction synergies.

Know the Difference

Board members are unlikely to bless a strategic acquisition with the intent to destroy value. Yet, too often, that is exactly what ends up happening. A disciplined, thorough, and independent valuation analysis can make the difference in helping a board distinguish a suitable match from a bad one. After establishing both the market value of the target and its pro forma value to a particular acquirer, a buyer is well-positioned to negotiate and—if all goes well—finalize the deal.

Justin Johnson is co-CEO of Valuation Research Corp. where he sits on the firm’s board and is a member of the firm’s Private Equity Industry Group and Financial Opinions Committee. Prior to joining VRC, Johnson held positions with Arthur Andersen, Merrill Lynch, and PricewaterhouseCoopers.

Beating the M&A Odds: Three Big Risks and Key Questions for Directors

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Director Essentials: Strengthening Oversight of M&A

Director Essentials: Strengthening M&A Oversight is available exclusively to NACD members. To become a member, please contact Brandan Nass at Join@NACDonline.org. To learn more about NACD, visit NACDonline.org

Every corporate director knows the importance of M&A in the grand scheme of enterprise. With some 40,000 significant transactions announced annually, M&A is hard to ignore. Yet there are persistent risks that directors need to understand and mitigate through insightful questions and the dialogue that ensues.

  1. Risk: Not all bets will pay off—at least not right away. Buying a company means placing a bet on the future. Given the level of unpredictability involved, there is some chance that the merger will fail to achieve its goals and/or fail to return incremental value to shareholders. It is commonly cited that “80 percent of all mergers fail” to add value; however, this percentage is an exaggeration. Event studies that compare transactions over time present a more realistic picture by showing that incremental financial value is not assured. For example, a study conducted by Kingston Duffie, publisher of the digital magazine Braid, indicates that companies actually lost 4.8 percent of their value when they spent at least five percent of their market capitalization on M&A during the 18-month period between October 2014 and March 2016. The interactive graphic included in the study shows differentiated performance during the period—high for Stamps.com Inc., medium for Starwood Hotels & Resorts Worldwide Inc., and low for EV Energy Partners. Your company could experience returns like any one of these.

Question for Directors: If this merger ends up having a slightly negative result for our shareholders, what are the compelling strategic reasons to do this deal? When do we believe that deal synergies will materialize?

  1. Risk: As a director, you could be named in a lawsuit—especially if you are voting on the sale of a company. In 2015, lawsuits were brought in 87.7 percent of completed takeovers. Although most cases settle, some do go to trial. In a trial setting there are four main standards for judging director conduct in the sale of the company, ranging from lenient to stringent:
  • The business judgment rule (trusting the decision as long as directors have no conflicts of interest and are reasonably well informed).
  • The Unocal standard (protecting anti-takeover moves only if a threat is real).
  • The Revlon standard (requiring an auction process once a company is in play).
  • Entire fairness (requiring both a fair price and a fair process).

In addition, when a company has promised its shareholders the right to have the company appraised, the court itself can impose its own valuation. In the original Dell go-private transaction, the court retroactively forced the company to pay aggrieved stockholders what the court deemed to be a missing increment to their premium.

Question for Directors: How can we find assurance that sale is in the best interest of the company and its owners, and that we have chosen an optimal price? How can we ensure that there is a litigation-ready record of our deliberations in this regard?

  1. Risk: You could lose your board seat. According to a study by Kevin W. McLaughlin and Chinmoy Ghosh of the University of Con­necticut, there is a higher rate of retention for directors from the acquiring firm (83 percent) following a merger, with the most likely survivors being individuals who serve on more than one outside board. Only about one-third of directors from the target board (34 percent of the inside directors and 29 percent of the outside directors) continue to serve after the merger.

This October, when Dell Inc. and EMC Corp. officially merge (assuming full regulatory clearance following their recent shareholder approval), many who serve on the EMC board may not be on the post-merger Dell board, including retiring EMC Chair-CEO Joe Tucci. When the merger was first announced last October, a spokesman for Elliott Management Corp. stated in a press release, “Elliott strongly supports this deal. As large stockholders, we have enjoyed a productive and collaborative dialogue with Joe Tucci and EMC’s Board and management. We are confident that this Board has worked tirelessly to evaluate all paths for the company and that today’s transaction represents the best outcome for stockholders.”

Saying goodbye to some or all of these incumbents this fall will seem to be an ironic outcome for creating value. And yet that is how it must be. Fiduciaries are not self-serving, but rather they serve on behalf of shareholders to promote the best interests of the company. As such, they need to be ready to move on when that is the best outcome for the corporation. Still, it is disruptive (and not always creatively so) to be a trusted voice of wisdom for the future one day, and mere history the next.  

Question for Directors: If we sell this company and our board must merge or disband, who among us will be most useful in steering the combined company in the next chapter?

These are not easy questions. But by asking them, directors can help their companies beat the tough M&A odds.

For more insights, see Director Essentials: Strengthening M&A Oversight, and Governance Challenges 2016: M&A Oversight—two new publications available without charge to all NACD members. See also “Does the Deal Fit the Strategy?” in Metropolitan Corporate Counsel, and “Project M&A” in Financier Worldwide.

Michael Woodford: CEO Turned Whistleblower

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Today marked an anniversary for former Olympus Corp. President and CEO Michael Woodford: the day he was fired from the camera and medical products manufacturer. What brought him to that day is a series of events that kicked off when Woodford had no choice but to blow the whistle on his own company after discovering a serious fraud.

Before being asked to assume the role of president–which he very gladly accepted–Woodford had a 30-year career at Olympus. Nevertheless, he knew that he wanted to make changes within the company, and soon into his presidency, an article in a business magazine titled Facta, ran an article about odd acquisitions Olympus had made and the high fees it paid a management consultancy.

When Woodford raised the issue with two managers in Japan about the article, he was told that CEO Tsuyoshi Kikukawa had advised them not to bring it up to Woodford. After demanding to speak to Kikukawa and Executive Vice President Hisashi Mori about the questionable acquisitions, Mori told Woodford that he worked for Kikukawa and that he was loyal to him.

Seeing no other option to raise the issue, Woodford wrote letters to the Olympus board and management and copied their auditor, Ernst & Young, on two of the letters. Instead of addressing the issue of the dubious acquisitions, the board unanimously ousted Woodford.

For more on the Olympus fraud, read an NACD Directorship magazine interview with Woodford from the March/April issue: http://www.directorship.com/exposing-fraud-at-any-cost/.