In a hot M&A market, the buzzword is buyer beware

by Robert F. Bruner
for Virginia Business
February 2006

Deal volume for mergers and acquisitions (M&As) in 2005 soared in the U.S. — 19 percent in terms of the value of all deals — and the figure was even higher for Europe at 21 percent. The market brought big, game-changing deals in industries as disparate as telecommunications, energy, business software, banking, and autos. When this happens, the thought-ful executive should grow cautious. One thing we’ve learned from past experience is that mergers and acquisitions engineered when the market is “hot” often lead to trouble.

In fact, in a study I made of transactions from 1985 to 2000, the worst deals were concentrated in the “hot” markets. They tended to feature relatively high deal prices; stock as payment was larger; merging firms less strategically related, and the deals followed a period in which the buyer’s share price outperformed a benchmark. Returns to the buyer’s shareholders sagged badly over the three years following a hot market deal.

Another team of researchers (Sarah Moeller, Frederic Schlingemann, and Rene Stulz) reported this astonishing outcome in examining more than 12,000 deals from 1980 to 2000: 87 of the large deals done in the late stage of the merger wave were sufficient to destroy value for the entire sample on average.

If the past is any guide, a sharp correction in the capital, currency, or commodities markets, or stiff-necked antitrust enforcement, might be enough to cool things down. But if M&As continue to heat up this year, a word to the wise: stay out of the game. If you can’t stay out, exercise extreme caution. And pay attention, because timing is everything. Listed below are a few things to look for when trying to pinpoint a hot M&A market:

• Sharp increase in activity. Define this relative to an industry rather than the entire economy. In Virginia last year, three sectors showed the most growth in numbers of deals: high tech, financials, and consumer products, while financials, industrials, and consumer products increased the most in terms of value.

• Higher prices, measured as a percentage premium offered by the buyer.

• Aggressive financing. This could mean the heavy use of debt and preferred stock to pay for a target, suggesting that buyers are reaching far beyond their prudent resources to do deals. Or it could mean the heavy issuance of common stock to exploit unrealistically high share prices.

• An increase in hostile bids. In 2005, hostile activity remained relatively low. The standout for Virginia firms was Qwest’s unsolicited bid to acquire MCI, a firm ultimately acquired by its chosen partner, Verizon.

• Talk of a “paradigm shift” accompanied by jumbo deals that redefine the competitive landscape. The merger of Citicorp and Travelers in 1998 marked the end of Glass-Steagall and the start of the biggest M&A boom in history.

• Entry by inexperienced, occasional and naïve acquirers and investors.

• Heavy use of risk management features. The heavy use of collars, contingent value rights, options, termination fees and wrangling over material adverse change clauses suggest that insiders are worried about something.

• Over-optimism. Most CEOs will say positive things about a deal to rally the employees and shareholders, but wear your humbug-detector. Look at the projected synergies: Are the profit margins and growth rates consistent with those of the best practice peers in the industry and/or with synergies in recent deals?

M&A activity comes in waves. We have had four large ones in the U.S., with the “mother of them all” (Time Warner-AOL) peaking in 2000. Waves are created by at least four factors:
The over-valuation of securities for brief periods during which buyers can borrow very cheaply and/or issue shares at inflated multiples. The CEO sees a correction coming and decides to buy sound assets with wampum. The poster child for this is AOL’s acquisition of Time Warner.

Firms naturally expand their investing behavior when the cost of capital declines. Thus, when interest rates fall and stock prices rise, more acquiring generally occurs.
Empire-building. This is the “bigger is better” mentality stimulated by the positive association between CEO pay and the size of the firm. Dennis Kozlowski’s expansion of Tyco would be an example.

Shocks to industries such as deregulation in banking, technological innovation in telecommunications, or trade liberalization in computing services. Each offers the important insight that what drives waves is highly context-specific. Truly, all M&A is local.

My advice: take the market’s “temperature” and move carefully. That looming M&A may not be all it seems.

Robert Bruner is Dean of the Darden School of Business at the University of Virginia. His book, "Deals from Hell," was published last spring by Wiley.