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.
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.
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).
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.
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.
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.
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 havinga 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?
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?
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.
Right now, M&A deal value is at its highest since the global financial crisis began, according to Dealogic. In the first half of 2015, deal value rose to $2.28 trillion—approaching the record-setting first half of 2007, when $2.59 trillion changed hands just before the onset of the financial crisis. Global healthcare deal value reached a record $346.7 billion in early 2015, which includes the highest-ever U.S. health M&A activity. And total global deal value for July 2015 alone was $549.7 billion worldwide, entering record books as the second highest monthly total for value since April 2007. The United States played an important part in this developing story: M&A deal value in the first half of 2015 exceeded the $1 trillion mark for announced U.S. targets, with a total of $1.2 trillion.
What is the board’s role in M&A?
This question can be answered in two words: readiness and oversight. At any given time, directors may need to consider either the sale of their own company or the purchase of another company. The key word here is may: nothing obliges a board to buy or sell if a transaction is not in the best interests of the company and its owners. After all, internal growth and independence usually remain options for a company under ordinary circumstances. Nonetheless, the board must still carefully weigh all opportunities to buy or sell as part of its routine corporate oversight.
Director responsibilities will vary by industry and company, but in general, corporate directors have duties of care and loyalty under state law which also apply in the M&A context.
Duty of care. The duty of care requires that directors be informed and exercise appropriate diligence and good faith as they make business decisions and otherwise fulfill their general oversight responsibilities. When reviewing plans to sell a company unit or to buy or merge with another company, the board must exercise proper oversight of management, especially with respect to issues of strategy and compliance with legal obligations such as mandatory disclosures. Pricing is another important consideration, and boards should be wary of claims of synergy. Academic studies offer mixed opinions on the track record for merger returns. Some find positive returns compared to non-acquiring peers (Petrova and Shafer, 2010), especially for frequent acquirers (Cass Business School and Intralinks, 2014). Other studies, for example a recent Fiduciary Group study citing McKinsey, claim a 70% failure rate.
Duty of loyalty. The duty of loyalty requires that a director act in the best interests of the corporation, including in the M&A context. Boards can maintain independence from an M&A transaction by appointing a standing committee of the board composed entirely of independent, non-conflicted directors to review the terms of a particular deal with the help of an independent third party, who can render a fairness opinion. (NACD submitted an amicus curiae letter on this issue in May 2015.) For a substantive legal discussion of the board’s role in M&A transactions, see this article by Holly J. Gregory of Sidley Austin, which appeared in Practical Law (May 2014).
Should the board be proactive in M&A, and if so, what are the most important questions directors should ask management about the opportunities and risks that M&A entails?
Even if your board is not currently considering an M&A transaction, it is important to remain aware of M&A as a strategic potential for the company, whether as buyer or seller. Here are some questions to ask, as noted in a recent article by Protiviti:
What potential opportunities and risks are involved in growing through acquisition?
Does M&A activity align with our current strategy and in what ways?
Looking at our portfolio of products and company units, are there any we might consider selling at this time? Why or why not?
Do we know the current market value of our company and its various units (if these are separable)?
What impact will a merger have on the boards of the combining companies, and how can boards weather the change?
M&A typically leads to a change in board composition, with the board of the acquired company (often referred to as the target board) usually being absorbed into the acquiring board. According to a study by Kevin W. McLaughlin and Chinmoy Ghosh of the University of Connecticut, among the mergers of Forbes 500 companies, most directors on the acquiring board (83%) stay on, while only about one-third of directors from the target board (34% of the inside directors and 29% of the outside directors) continue to serve after the merger. The study also shows that for acquiring company boards, outside directors who sit on more than one other outside board have a higher chance of remaining members. For both acquirers and targets, outside directors with CEO experience are more likely to keep their seats.
In the September–October 2014 issue of NACD Directorship, Johanne Bouchard and Ken Smith consider these findings and offer “Advice for Effective Board Mergers.” Their article outlines what boards can do to prepare for their own mergers. “Whether the board composition changes as a result of the merger or acquisition,” they note, “the board will benefit from holding a special session (or sometimes multiple sessions) to regroup and align before going into the first official board meeting.” At that first meeting they can get to know each other and the leadership team, check strategy, transfer knowledge, establish the role of the board chair, and “begin to function as an effective board.”
If the board is approached by management or a third party with a proposal to buy another company, what issues and questions should directors raise?
The extent of the board’s involvement in a proposed transaction will vary depending on the size of the acquisition and the risks it may pose. If a very large company regularly buys smaller companies in its industry and has already developed a process for finding, acquiring, and integrating these firms, boards need not focus on the details of any particular transaction. They can and should, however, periodically review the entire merger process, from strategy to integration, in the context of strategic opportunities, attendant risks, and operational implications, to make sure that the process is sound and functional.
The board’s primary role is to perform a reality check on management’s plans. A common claim in proposed mergers is that the whole will be greater than the sum of its parts—what Mark Sirower of Deloitte calls “the synergy trap” in his classic book of that name. But the challenges of integration can often result in a loss of value, an issue that is explored in noteworthy articles from McKinsey and Protiviti. Drawing on these articles as well as the thoughtful questions raised in the Report of the NACD Blue Ribbon Commission on Strategy Development, we have compiled a few queries the board may wish to put to managers and advisors.
Strategic considerations: Why are we considering this deal? If there are synergies, what hard evidence indicates that they will materialize?
Tactical considerations: What processes are now in place to create a pipeline of potential acquisitions, close deals, and execute the post-M&A integration?
Risk: What is the company’s current risk profile, and how does it correspond to the company’s risk appetite?
Capital and cost implications: Does our company have the cash on hand, projected cash flow, and/or available credit to commit to this transaction?
Operations: What changes will need to be made to the current operating structure and logistics following the merger? Will the supply chain be affected?
Talent: As we blend the human resources from the two companies, will we have the right talent to make this merger a success?
Technology: Is the company’s technology infrastructure capable of supporting the planned merger? How will the acquired company’s technology be treated post-merger?
Culture: Will the merger involve a blending of two different cultures? Do we foresee conflicts? If so, what are our plans for resolving them? Will there be a new postmerger culture? How can we ensure that all retained employees thrive in the new environment?
Monitoring Progress: What are the dashboard components for this deal? What elements will management monitor and how frequently? What dashboard metrics will the board use to measure the transaction’s overall success?
If the board is approached by management or a third party to sell the company or a company unit, what issues and questions should directors raise?
While many constituencies will have a stake in any proposed company sale (including notably employees), shareholders’ main focus will be price. The two critical legal considerations in this regard are the Revlon doctrine (for public companies) and fraudulent conveyance (for asset-based transactions, usually relating to private companies).
Revlon doctrine. In the landmark case of Revlon Inc. vs. MacAndrews & Forbes Holdings (1986), the court described the role of the board of directors as that of a price-oriented “neutral auctioneer” once a decision has been made to sell the company. This Revlon “doctrine” or “standard” is alive and well even today. It was cited in the In re: Family Dollar Stores decision of December 2014, in which the court denied a stockholder action claiming that the Family Dollar Stores board had violated its Revlon duty by merging with Dollar Tree Inc. and by failing to consider a bid from Dollar General Corp. According to recent commentary by Francis G.X. Pileggi, a regular columnist for NACD Directorship, this case showed an “enhanced scrutiny standard of review for breach of fiduciary duty claims under the Revlon standard.”
Fraudulent conveyance. All company directors, whether of public or private companies, have a duty to make sure that the company being sold is represented accurately to the buyer. Otherwise they can be sued for approving a “fraudulent conveyance,” especially in an asset sale. Fraudulent conveyance lawsuits became very common during the leveraged buyout era of the 1980s, when acquirers that overpaid for assets using borrowed funds failed to generate returns and tried to recoup losses. This longstanding legal concept, like the Revlon doctrine, is still in current use and was recently cited in relation to the LyondellBasell merger, according to the law firm of Kurtzman Carson Consultants LLC.
In light of these concerns, questions to ask before approving the sale of a company or a division might include the following:
Are we certain that the sale is our best option? Have we assessed alternatives?
Under state law and/or our bylaws, do shareholders need to approve this sale?
Have we received a valid fairness opinion on the price?
Does this sale conform with the Revlon doctrine?
If this is an asset sale, are we sure that the assets have been properly appraised?
By asking the kinds of questions discussed in this brief commentary, boards can improve the chances that any M&A transaction, if pursued, will create optimal value for all participants.