On the back of record low interest rates, an ongoing improvement in the world economy, favourable financial market conditions and higher confidence by CEOs, a surge in global mergers and acquisitions (M&A) took place over the past year. In addition to the flurry of US deals, a growing number of cross-Atlantic mergers occurred, for example Walgreens buying Alliance Boots and Siemens buying Dresser-Rand. But the peak in the M&A cycle has yet to be reached, as indicated by the number of large deals announced so far in 2015. Against the backdrop of the likes of Shell buying BG Group, Heinz buying Kraft Foods and AbbVie acquiring Pharmacyclics, the number of large deals already exceeds last year’s.
Companies undertake M&As for a variety of reasons, including the pursuit of growth, diversification of their businesses or to consolidate an industry. The most common rationales for such deals are industry capacity reduction, the extension of product or market lines, geographic roll-ups, industry convergence and a substitute for in-house research and development capabilities. Often, tax also acts as a motivator. In 2014, we saw increased M&A activity related at least partly to tax inversions, which involves companies’ deliberate relocation of their legal headquarters overseas to reduce tax payments. Among those were Pfizer’s attempted acquisition of AstraZeneca, which would have significantly reduced the company’s effective tax rate, AbbVie’s attempted acquisition of Shire and Burger King’s bid for Tim Hortons.
The value to shareholders
Empirical evidence shows that on balance acquisitions create economic value. Shareholders of targets gain overall, while shareholders of acquirers experience mixed results. The main reason why most M&A deals fail to create value for buyers is that acquirers tend to pay too much for targets. A host of factors might explain this tendency, including an overly optimistic assessment of market potential, an overestimation of synergies, poor due diligence and hubris.
While it stands to reason that company executives would seek to create shareholder value with the deals they agree, the evidence shows that most do not. Often, executives focus on accounting-based measures instead of considering the extent to which synergies can exceed the premium paid to shareholders. Executives view earnings per share (EPS) accretion favourably and dilution unfavourably. Nonetheless, just like with other investments, the immediate EPS impact gives little indication of a deal’s prospects for creating long-term value.
At Hermes EOS, we take a particular interest in the acquisitive growth of companies to establish that the investment plans have been critically analysed in terms of their ability to create long-term shareholder value. Equally important is to check whether the deals follow the communicated acquisition criteria. Unfortunately, on occasions even sensible self-imposed acquisition hurdles – such as the need to have positive economic value added or generate double-digit cash flow returns within a couple of years after closing of a transaction – are disregarded when a takeover is classified as strategic. While this may exceptionally be justified, disregarding communicated acquisition criteria without adequate explanation may impact the trust and confidence of investors.