59: Two sick men don’t make an healthy man

Mergers and investments can occur for various reasons, normally growth and expansion such as entering new markets, acquiring new competencies, or increasing the customer base, or synergies, like combining organizations to optimise production or delivery costs. Other motivations can be diversification, access to innovation or patents, talent acquisition, and tax benefits… the list goes on[1].

There are also less good reasons for mergers, especially in growing industries where justifications for growth or 'strategic' opportunities may be overstated. In M&A, managers often overestimate their ability to enhance the target company (the hubris hypothesis) or aim to increase scale without a clear plan for leveraging it, or the money needed to scale the investments.

A critical issue is the temptation to merge two struggling companies under the assumption that combining them will yield positive results (assuming 0+0=2). This scenario is like bringing together two sick people to make a healthy one - more often, the combined entity inherits the weaknesses of both, leading to further decline. In fact, not only 0+0 can equal -1, but even 1+0 might result in zero, with the 'bad apple' contaminating the good one.

In immature industries with many underperforming players, or declining industries with established players, the temptation is strong: let’s consolidate!

However, history suggests it's better to pass on poor targets and focus on strengthening one's own business and definitely to avoid merging two underperforming entities. This principle applies on a smaller scale as well: combining two underperforming teams, business units, or offerings is unlikely to lead to a great outcome.

At times, there may be pressure from markets, leading boards to feel compelled to pursue high-profile acquisitions to appear proactive or responsive to investor demands, even if the transaction lacks strategic alignment. These "headline-driven" deals are often rushed and tend to end up in, investors’, tears. Some might be in the making as you read this.

[1] If you are keen on the literature here there are several good papers, some pro, some against. One pro is by Michael C. Jensen and Richard S. Ruback (1983). “The Market for Corporate Control: The Scientific Evidence”,? “Do Acquisitions Destroy Value? Evidence on the Acquisition Performance of European Firms” by Roberto Gugler, Dennis Mueller, and B. Burcin Yurtoglu (2003) instead examines the performance of M&A deals, specifically in the European context, and highlights factors that can lead to value creation or destruction in acquisitions. “Performance of Acquiring Firms in Unrelated Industries” by Richard Roll (1986) introduces the “hubris hypothesis” in M&A, which suggests that acquisitions may sometimes be driven by the overconfidence of managers rather than rational economic factors. Non exhaustive!