Baruch Lev is Philip Bardes professor emeritus of Accounting and Finance, Kaufman Management Center, Leonard N. Stern School of Business at New York University. Feng Gu is chair and professor of Accounting and Law at the School of Management, State University of New York at Buffalo. Together, they recently published The M&A Failure Trap: Why So Many Mergers and Acquisitions Fail, and How the Few Succeed (Wiley). They discuss their findings, and the lessons they drew for would be acquirers, with Global Finance.
Global Finance: Why did you write this book now? What is it about the current M&A environment that prompted you?
Lev: Three years ago, Feng and I, as keen observers of M&A, saw several troubling things. There was a large, continuous increase in write-offs of goodwill in investment in acquisitions. Write-offs are basically a recognition by management of a partial or total failure of the acquisition, which is a very bad sign, particularly if it’s increasing over time. We also saw, to our surprise, a huge spike in the last 10 to 15 years in conglomerate mergers: mergers of unrelated entities where there are no synergies. And basically, all of them, or most of them would fail, but there is still a large increase in conglomerate mergers. We also saw a large increase in stock prices, which is usually followed by large merger waves.
GF: What methodology did you follow to study mergers, and what were your top-level findings?
Lev: We took a sample of no less than 40,000 acquisitions, a really representative sample over the last 40 years, and applied quite advanced statistics to it. We found some amazing things. One is that the failure rate of acquisitions is 70% to 75%, where those acquisitions don’t increase sales or decrease costs or create shareholder value. You would expect managers who are going to do these extremely expensive, elaborate deals to learn from what they do, and what we found is, there really is not a learning curve, more like an unlearning curve.
I would like to focus for a minute on some overall attributes. Most CEOs are confident; that’s how you get there. But overconfidence means that they believe their abilities to acquire, to invest, are substantially above their real abilities, and studies have shown that something like 30%, 40% of CEOs are overconfident. One of the main characteristics of an overconfident CEO is multiple acquisitions. They are convinced that even if they take losers, they will turn them into great winners.
We also focus on something that I didn’t see before in the literature, and that’s the wrong incentives for managers. Most companies pay CEOs an acquisition bonus. These bonuses are quite large, $5 million, $15 million, $20 million, and they are paid for conducting the acquisition, not conducting successful acquisitions. And we found something else that we didn’t see before. If you look at buyers in general, their operating position, their earnings, their sales, are weakening over time.
And of course, the reason to buy is somehow to revive the business model. But a weak buyer is an invitation to failure. Its stock prices is usually too low to use for acquisition, so it has to raise debt, which is very, very oppressive. And the talent of the target doesn’t like to move to work for buyers’ with lagging operations.
Gu: The human element is a frequently ignored aspect of M&A, and we put a lot of effort into uncovering some previously unknown, important patterns concerning the behavior of employees around the time of acquisition. For example, as soon as a merger or acquisition announcement is made, the employees of the target company start leaving. Many of them realize, okay, we know from previous experience, once two companies are merged, many employees would lose their jobs. So, especially the most talented employees don’t want to wait until this happens to them. And after the acquisition, the same trend basically continues, but this time, most of that is likely driven by the merged company’s decision to increase efficiency by laying off employees in order to create synergies like cost savings. After several years of this squeeze, employee productivity has continued to decline. In fact, you don’t see, generally, employee productivity recovering to the pre-acquisition level.
GF: About the loss of talent, can better, more timely communication help prevent this?
Lev: Managers usually provide very extensive information upon the acquisition announcement, and studies have shown that most of this information is highly optimistic. They speak about huge synergies to come and great things to be had from the acquisitions. I would say, if you cut 50% of this—excuse me—bullshit, and you provide a plan, particularly that shows how employees of the target will be integrated into the new company, what new positions are awaiting them, what things they should do, like moving from country to country, reducing the uncertainty and focusing on the new opportunities they will have, perhaps with some financial incentives, more of them may stay.
GF: Is there anything systematic that would-be acquirers can do to anticipate success or failure?
Lev: We introduce a new idea to the M&A literature, an acquisition scorecard. We used our statistical model to identify the 10 most important factors that either positively or negatively affect the consequences of acquisitions, and we weighted them accordingly. Some factors are more important than others, particularly for executives contemplating an acquisition. We provide a very user-friendly tool where you just insert the numbers from the target and from the buyer, and you get a score indicating the likelihood of success.
GF: When is a company well-placed to make an acquisition?
Lev: The ideal buyer would look like a company that is doing reasonably well, not necessarily incredibly well; a company that can use some of its stock for payment, not just cash; a company that will be attractive to employees of the target. So don’t wait until a crisis is at its peak and you incur losses, lose market share, lose customers. That’s a bad time to buy. Look ahead! Look ahead to when your patents are going to expire. Look ahead to your business model, when it’s going to plateau. Look at the competition who are creeping up on you, and then, relatively early, make a decision and buy. Don’t wait until it’s too late.
GF: When it comes to due diligence, what should managers be doing to avoid a rude surprise?
Lev: One important element of successful due diligence is to look at the accounting. I know it’s boring—definitely for the CEO and maybe even the CFO—but a good analysis of the target’s books is essential. In the case of Hewlett-Packard’s buying of Autonomy, a forensic accountant has shown that you could have seen easily that their books were manipulated for 10 years prior. Every quarter it either met or exceeded analysts’ revenue forecasts. This is impossible, I think, even for Amazon. So do even the mundane things seriously: go over the accounting, the contracts, and then, of course, all the human elements. You want to be sure that what you buy is worth the price. Gu: Another area of failure in due diligence is technologyrelated. Nowadays a growing number of non-tech companies are buying tech startups, trying to modernize their business model. The main asset they’re trying to acquire is not a physical asset, it’s not inventory, it’s not even cash. It’s the alleged technology used by the target to penetrate a new type of market. If the buyer does not do a very good job in due diligence to really verify the technology they are trying to acquire, it can turn out to be worthless to the buyer. Later on, we’ll see a huge goodwill write-off showing a completely failed acquisition: very, very embarrassing for the CEO of the buying company.
GF: What are the most important things that a would-be acquirer can do to improve its chances of success?
Lev: First, they should change the incentives; incentives for acquisitions should be given only for successful acquisitions.
