Why Most Mergers Fail? Revisiting Some Basics

Introduction

Mergers and acquisitions (M&A), remain an important growth tool deployed by companies around the world. Despite a near consensus that most mergers fail or harm the value for the acquiring firm’s shareholders, many companies continue to pursue M&A deals with objectives such as gaining market entry, increasing market share, eliminating competition, achieving economies of scale, acquiring resources & capabilities, influencing supply chains, avoiding business collapse, and stimulating growth, etc.

In this context, this discussion is an attempt to:

• evaluate the way in which takeover / M&A targets are identified.
• examine the motives for M&A activity and why an M&A based only diversification could be considered a poor motivation?
• evaluate why M&As fail and discuss what is meant by the term “failure”.

Although the term M&A is used casually in the financial press to mean all types of deals, the terms mergers and acquisitions do have somewhat different meanings. Speaking in very broad terms, when two rather equal (or comparable) size companies combine their businesses to achieve operational economies or strategic targets, the transaction is usually referred to as a merger. An acquisition on the other hand usually means a larger company acquiring a smaller company, induced by a set of objectives, usually resulting in the pursuit of the acquiring company’s strategy.

With the background of the belief that most mergers fail to achieve intended objectives, let us now try to understand how companies could go about M&A activity and why most M&As fail.

How can a company identify potential M&A targets?

M&As as a means of growth/survival could have many possible motivations. Unlike a financial acquirer (that acquires a company as a portfolio investment, to be sold later), most businesses looking for targets are trade acquirers (operating firms), and their acquisition target identification & selection must be guided by a clear sense of their mission and overall business and growth strategy.

Despite sufficient empirical evidence to suggest that nearly two-thirds of all M&As fail to achieve intended objectives, the intentions of every acquiring firm whilst identifying possible targets, without a doubt, are of achieving success. With the wealth of M&A-related data available to us, covering four major M&A waves occurring post-1980, we are now able to identify core patterns and linkages among a variety of very complicated factors at play in defining the probability of M&A success.

Speaking in broad terms, the fundamental M&As success criteria could be understood from the perspective of the continuing shareholders of the firm i.e., if acquisition purchase premium (price paid for a target over and above its pre-bid share price) is less than the net realizable synergies ( the estimated future cost savings or revenue enhancements, adjusted for offsets, delays and/or truncated duration).

The probability of achieving this near enigmatic success (among other factors such as the size of the APP) is closely related to the choice of target. Companies usually begin their M&A journey by developing an acquisition strategy. Once they have some sort of understanding of why they want to pursue M&A as a strategy, they can create criteria for the types of companies they want to acquire. With that criterion more or less established, they can then start to search the suitable targets. On the practical side of doing it, usually, companies use tools like pitchbook (https://pitchbook.com/), S&P Capital IQ, or Bloomberg. Alternatively, in addition, companies can engage investment bankers or other professionals to search for potential targets.

To identify candidates for M&A opportunities, seeking guidance from a well-defined merger segmentation framework (for evaluating, qualifying, and classifying candidates for merger opportunities) can increase the chances of success. Though not an exact science, with the wealth of M&A-related data and some vast academic research available to us, we can attempt to understand some important target attributes or dimensions which could have a direct bearing on the success of the M&A initiatives.

Targets in related industries

The first such dimension is the relatedness of the target’s business. Attempting to diversify into unrelated businesses can trigger reverse synergies i.e., less efficient post-acquisition operations owing to a lack of understanding of the target’s business and its value drivers.

Relatedness could mean businesses with the same industrial classification as well as similar business models. A target in the same industry as well as with a similar business model is (broadly speaking) more likely to offer greater chances of M&A success. The post-merger integration (PMI) efforts could be more effective and the realization of synergies more achievable. Examples of business model mismatch would include a traditional premium airline acquiring a no-frills subsidiary. The two whilst belonging to the same industry (aviation) has very distinct operating philosophies and critical success factors. Synergistic gains could be hard to accomplish and impacts on both brand’s perceptions could be irreversibly harmful.

Whilst relatedness of the target’s business is an important consideration, an individual acquirer’s circumstances or strategic objectives could induce the management to actively go against that. For instance, low or no growth prospects in the acquirer’s industry, availability of a bargain opportunity, and an acute need for business transformation by venturing out of a dying industry or product.

Relative target size

The second most important dimension/target attribute is the relative size (primarily in terms of revenue) of the intended target/merger partner. A relatively smaller acquisition target is easier to understand and integrate. Empirical evidence and scholarly M&A research show that when the acquiring firm is much larger than the acquirer, the chances of success increase. The manageable size and complexity of the target firm make it relatively easier to better assess the synergies possibly resulting in a bid price that could minimize acquisition purchase premium (APP). The PMI processes stand a better chance of realizing those synergies, hence possible reduction in the value gap.

In one of the best-known M&A segmentation-related research papers, Coley & Renton (The Hunt For Value, 1988) point out that the chances of M&A success increase from a mere 14% for a combination of unrelated businesses and relatively larger target to 45% for a reverse combination.

Similarly, a target’s acquisition resulting in a horizontal merger (where the acquirer and the and the target are operating at the same level of the value chain in the same industry) presents much better chances of merger success compared to a vertical merger (where the acquirer seeks to expand into upstream or downstream activities of the value chain). Horizontal mergers are more likely to be focus increasing and could result in an increase in market power and improvement in economies of scale. However, at the same time, attempting to acquire targets in horizontal space could possibly trigger regulator intervention if the merger is likely to result in a significantly large market share.

Geography

Whilst it could sometimes be a well-thought-out strategy to expand internationally by venturing into new geographies, scholarly research shows that M&As involving targets in distant locations have much smaller chances of success compared to domestic acquisitions. Azofra et al.’s (2007, 5) observe about geographic diversification “M&A’s leading to diversification, be it geographically or by activity, tend to have worse results than those that lead to concentration.”

Simple logic dictates that the chances of fully understanding the strategic environment (and the resulting opportunities and threats that it presents) in foreign lands are limited compared to a domestic target. This combined with the cultural differences, the prospects of increased costs due to logistics and supervision needs, and the complexities of the legal & governance systems make it difficult to realize intended synergies.

Merger deal types

Whilst identifying suitable M&A targets, acquirers could possibly enhance their chances of success by carefully manipulating some known correlations between success and the types of merger deals. One such type is referred to as Bottom Trawlers which has an estimated success rate of 87-92% deal success. The word “bottom” refers to the status of the targets and “Trawlers” refers to bargain-seeking acquirers. Bottom Trawlers actively search for targets in distress, which have publicly declared that they could no longer compete. The logic being, a target in distress could be available at a minimal price and APP, increasing the success chances and reducing the cost of failure.

Another such type is referred to as Bolt-Ons which is estimated to have a success profile of 80-85%. It implies that acquirers target businesses that can fill voids in their product/service offerings quickly, hence the term Bolt-Ons. Acquisition of Tropicana? by PepsiCo or Procter & Gamble’s purchase of Pantene are suitable examples. The acquiring company is likely to have a good understanding of the products, their markets as well as their business models, potentially reducing APP and increasing the chances of synergy realization.

A very similar type is referred to as Line Extension Equivalents which has an estimated success profile of 65-70%. It involves the identification of targets that can extend the acquirer’s offerings to specific niches in the same or similar markets through next-generation or different variants of the existing products and services. An example is Volkswagen’s acquisition of Skoda. It provided VW access to lower price segments of the automobile market and also resulted in cost synergies.

Industry development stage

Acquirers in a mature (stable and mid-life in terms of economic lifespan) industry, can target companies within the same industry for consolidation, market share, scale economies, and overhead synergies. Such an approach is referred to as Consolidation Mature and is estimated to have a success rate of 55-60%. The major threat to success with this approach is the overestimation of the importance of market share gain. Conversely, similar consolidation occurring in the emerging industries (referred to as Consolidation-Emerging) has a much lower estimated success rate of 37-42%.?

Complimenting targets

Another approach is to identify targets that could provide multiple (2 or more related elements) logical compliments to the acquirer’s present products, services, or distribution channels. The resulting merger is referred to as Multiple Core Related Complimentary and is estimated to have a success rate of 40-45%. Prominent examples would be Disney and ABC, and P&G and Gillette. The major threat to success with this merger type is off-course possible errors in judging the development potential and revenue synergies.

Sometimes, however, acquirers identify targets that only have a very week connection with the acquirer’s base businesses. Perhaps judgment errors or over-enthusiasm results in creating an exaggerated picture of benefits attributed to the target. The resulting mergers are referred to as Single Core Related Complementary and are estimated to have a success rate of 30-35%. Good examples include eBay-PayPal and Daimler-Chrysler.

Business model transformation

Certain companies could be caught in circumstances where the primary business is dying and the going concern is in question. The survival needs some transformation at the least and if M&A is thought to be a survival/transformation strategy, then targets could be identified in unrelated industries which could provide a supplemental core business. The resulting merger is referred to as Lynchpin Strategic and is estimated to have a success rate of 20-25%.

Sometimes though, not necessarily induced by survival crises, acquirers indulge with radical high-risk experimentation with their business mix and model. Guided by a CEO’s imaginary vision that is inconsistent with market realities, acquirers could venture into completely unchartered waters. The resulting merger is referred to as Speculative Strategic and has an estimated success rate of 15-20%. Coca-Cola’s acquisition of Columbia Pictures, AOL-TimeWarner, and eBay-Skype are some prominent examples.

Why an M&A based only on diversification motive could be considered a poor motivation?

As we pointed out in the above discussion, M&A activity could have many motivations. These would include:

• a need/wish for business diversification (industry, products & services, geographies, etc.).
• a search for filling believed voids in existing product & service offerings, and/or developing capabilities for providing next generation or different variants or compliments of existing products and services.
• seeking market entry and/or increase in market power.
• capitalize on the opportunities for the purchase of assets/competitors at a bargain price.
• achieve accelerated growth.
• eliminate competition.
• achieve economies of scale.
• acquire specific resources & capabilities.
• influence supply chain.
• transform existing business mix and model.
• avoid business collapse.
• managerial self-interest, etc.?

Whilst an individual firm’s unique circumstances could produce a good business case for an M&A strategy based on any of these motives, vast amounts of empirical M&A data, as well as scholarly studies, suggest that not every M&A motivation (and resulting strategy) is likely to lead to the similar probability of success.

Diversification of business could theoretically (and also in practice) provide a firm with a larger market, increased revenues, reduced cyclicity & variability in the firm’s revenues, and could possibly reduce risk. In the 1970s, Multi-companies (conglomerates) were considered to represent financial value magic. This sentiment was based on two beliefs: (1), a holding company with investments in diverse sectors was more insulated from industry-specific down-turns; and (2), a diverse business combination/portfolio could better guarantee a value-maximizing cashflow transfer from cash-cows into stars i.e., high potential value SBUs which need resource injection for turning into cash-cows.

However, the years that followed, exposed us to four major M&A waves (post-1980) and left us with a wealth of data to mine and identify core patterns and correlations. Today, it is widely believed that M&As based on diversification strategy alone stand a smaller chance to be accretive and normally are value-destroying. If M&A success is to be measured primarily by the excess of NRS over the APP, simple logic dictates that the acquiring firm’s lack of expertise about the industry/business model of a target will likely result in reverse synergies i.e., less efficient post-merger operations possibly increasing costs and reducing revenues.

Scholarly research has shown evidence that firms with multiple businesses trade at a discount of between 5 and 10% on individual firm values. The research attributes this to a diversification discount.

Azofra et al. (2007, 5) group business type diversification with geographic diversification as related threats to merger success: “M&A’s leading to diversification, be it geographically or by activity, tend to have worse results than those that lead to concentration (Houston et al. 2001; Marqueira et al. 1998).”

Let us now attempt to identify the logical basis for the above-mentioned scholarly research conclusions. The fundamental point to stress is that the management of the acquiring company usually has little ability to fully understand an unrelated business in a short period, possibly resulting in wrong judgments, wrong assessments, and merger value destruction. In other words, lack of focus increases complexity and owing to a lack of familiarity with the target’s industry/business model, reduces the ability of the acquirer to correctly estimate and then realize the assumed synergies. This results in a widening adverse value gap and chances of success decrease. Combine this with other PMI difficulties including logistics and administrative problems and the assertions start to make perfect sense.

Jumping to a completely unrelated industry for sure poses very clear pre and post-merger challenges for the acquirer. However, there could be circumstances where there is a specific need for such a strategy. For instance, the availability of a hard to resist bargain opportunity in an unrelated industry or an acute need to venture out of a dying industry seeking survival (Lynchpin Strategic).??

Nonetheless, regardless of the motivating circumstances, the fact remains that the acquirer is greatly unfamiliar with the target business and a high probability of reverse synergies persist. Where diversification is needed as a survival strategy, added problems could emerge. i.e., the seller possibly senses the level of the acquirer’s desperation for the deal and gets an upper hand in negotiations. This is especially true if the target is already a well-managed company. The value gaps could increase and the chances of success diminish further.

Diversification through the acquisition of businesses that apparently operate in the same or similar industries but have very different business and operating models could also pose similar challenges and could be very value destructive. Easy to relate examples would include a traditional airline operator like BA or Emirates acquiring a no-frill subsidiary. On the surface, both operate in the same industry (aviation) but their operating philosophy, cost structures, success factors, and fundamental business models are completely different. As we have seen with many such attempts in the recent past, these types of transactions often fail. Another example could be mergers between successful consumer and business banks. Citigroup’s difficulty during the subprime-derivatives bubble is a testament.

Another challenging dimension of diversification strategy is geographic diversification.

Azofra et al.’s (2007, 5) observe about geographic diversification (“M&As leading to diversification, be it geographically or by activity, tend to have worse results than those that lead to concentration.”). Diaz, a co-author of the Azofra et al. paper, came up with his perspective in a separate paper two years later, referring to Houston and Ryngaert’s 1994 study: “Domestic M&As offer a greater potential for obtaining synergies derived, for example, from the elimination of redundant costs by geographical overlapping.”

Although there could be circumstances where a firm faces little or no growth prospects in the domestic market and has little choice but to plan expansion into foreign territories, more often than not, a wish for geographical expansion is based on the greener grass error. Ignorance is bliss and could create fantastic pictures. Lack of knowledge about the foreign target market and limitations of properly diagnosing foreign opportunities, make the distant lands appear way more promising compared to the known territory where the acquirer’s awareness of challenges is at a different level altogether. The resulting assessment of opportunities could be extremely faulty and the estimation of synergies over-enthusiastic.

Perhaps a glaring example would be NatWest’s acquisition of Gleacher (a Manhattan investment bank), which represents the failure contributing impact of both lack of expertise in an industry niche (investment banking) and wrong reading of a foreign market (regulatory environment and growth prospects in the US). This resulted in a hasty retreat and adverse effects on its core banking business in the UK.

A firm’s growth strategy must be well-rounded, and well-thought-out. i.e., choice of diversification as a growth direction must be based on a sound understanding of its core strengths & weaknesses, thorough assessment of the available opportunities, and full awareness of the possible threats to its core business. There could be circumstances and opportunities where diversification has a very strong business case. A bargain deal availability, an opportunity for an entry into a fast-growing market segment, favorable terms offered by a foreign govt. etc., are all good examples. However, diversification just for the sake of it, i.e., radical and high-risk experimentation with a firm’s business model & mix, guided by an enthusiastic CEO’s faulty business vision is very often a good recipe for disaster.

Why do so many M&As fail?

There is a near consensus on the fact that most mergers fail. It is believed that the success rate is a mere one-third or all M&A, meaning that two-thirds of all these transactions fail. Before we can comment on why merger failure has such a high rate, we need to understand what is merger failure?

In simplest of terms, a merger is deemed to be a failure if it results in value destruction for the continuing shareholders of the acquiring firm. An acquisition is a capital investment i.e., shareholders of the buying firm invest in an asset and expect to gain from this investment. Taking our simple logic further, value is destroyed for the buying firm’s shareholders if they end up paying more for the asset that they’ve acquired than what it is worth.

A primary motivation behind most mergers is hope for synergies. Meaning the combined post-merger firm finds more operational efficiency (through economies of scale and elimination of duplicate expenses etc.) or enhanced revenues or both and thus become worth more than a simple addition of the standalone value of both. For this reason, prices paid for acquisitions are normally more than the standalone value of the target. This excess or difference is referred to as Acquisition Purchase Premium or APP. For the M&A deal to be considered successful, the APP has to be lower than the estimated value of Net Realizable Synergies (NRS).

When it is asserted that two-thirds of all M&As fail, it by default means that in two-thirds of the instances, the APP eventually is demonstrated to be higher than the NRS. With this basic fact established, let us now try to understand why this happens?

Based on a wealth of M&A-related data and vast scholarly research on M&A patterns, we know that post-1980, we have witnessed four M&A waves, each with its distinct features as well as common patterns. Why mergers and acquisitions come in waves is perhaps not fully understood but we do know the common progression patterns.

Each wave has four distinct phases and the chances of M&As success fade as the phases of a merger wage age. In the beginning phases of a merger wave, the APP levels are considerably lower, and owing to very little activity in the market the choices are ample. As the phases progress, the reverse happens i.e., the APP levels tend to rise and the choices available shrink. Two separate scholarly studies suggest that most mergers fail when the APP exceeds 37-38%.

The merger waves tend to follow the economic cycles i.e., as soon as there are green shoots of an economic recovery (after a recession or a crisis such as subprime crises of the late 2000s) some activity begins. As the economy and businesses are generally still not in a very good condition, deals are struck at near bargain prices, keeping APP to low levels. However, as the activity picks up, fueled by an improving economy & sentiments as well as by better availability of finance, the anticipation of APP starts to reflect in the pre-bid prices or available targets, pushing APP levels higher.

In the third phase, the activity accelerates since the merger boom is now legitimized and those who were earlier reluctant, now decide to take the plunge. As the phases, progress, and transactions conclude, the choices for latecomers squeeze, which exacerbates the problem through high APP levels and shortage of good-fit acquisition targets.??

In late phase deals, therefore, the prospect of merger value destruction is high as eager acquirers (in their hunger to rise the tide) tend to make wrong synergy assessments (overestimating) and likely end up with the toxic combination of high bid price and overestimated synergies. APP levels in the fourth phase could be as high as three digits, as opposed to as low as 10% in the beginning phase. Meaning that the deals are nearly ‘dead on arrival' since it is simply not possible to make up for that premium with synergies.?

A few good examples of mergers taking place in the ending phases of past M&A waves would include AOL/Time Warner, RBS/ABN Amero, JPMC/Bear Stearns, Pfizer/Allergan, DEL/EMC.

Let us now look at the agency problems which also contribute to the high M&A failure rate. A CEO either induced by board pressure to act or guided by self-interest motives could end up venturing into hot waters i.e., as the merger waves progress and the pressure on a laggard CEO increases, so do the chances for making wrong judgments. With shrinking choices and rising APP levels, the chances of success recede but are induced by the ‘need to act’ most act, at APP levels which affirm a deal’s failure. The situation is exacerbated by the enthusiastic investment bankers and deal advisors for whom the success is defined by the closure of the deal, and a board that does not necessarily have a good comprehension of MergVal basics. Caught between a rock and a hard place (two or more missed closes often means that the chief executive should begin preparing for the sack) the CEO decides to just go ahead with the deal.

Wrong estimation of synergies could take some time to become apparent. i.e., it takes some time before it is realized that synergies were wrongly and overestimated. Most reliable sources of synergy include elimination of some overlapping administrative bureaucracies, scale efficiencies, and limited discontinuation and organizational delayering. It takes expert judgment and deep knowledge of the related industries to estimate synergies without material errors. Examples of these errors include, but are not limited to:

a.??????presuming that an impossible percentage of costs may be cut

b.??????counting revenues or net income effect rather than cash flow

c.??????missing or ignoring synergy offsets, delays, or truncated duration.

Both the chances of estimation errors and lost opportunities through less than optimum PMI program implementation increase when the acquirers venture into unrelated businesses or foreign geographies through M&A. As discussed earlier, the lack of knowledge about a certain industry or geography could significantly limit the ability of the acquirer’s management to accurately estimate synergy opportunities and then to realize those synergies through effective use of a well-designed PMI program. The results of NatWest’s attempt with investment banking in a foreign territory, quoted earlier in the discussion is a very good example to be quoted again.

Whilst we know that two-third of M&A fail, we must also look at the flipside figure i.e., one-third do succeed. If the majority of this two-third failure rate is attributed to wrong decisions made, one could argue that a vast majority of M&As which are made based on good business case decisions do succeed. Which in turn would mean that by eliminating those wrong decisions, the M&A success rate could improve dramatically. However, that would also mean far fewer deals and far lower fees for the deal advisors. We can therefore argue that that is some coloration between the vested interest of deal advisors and a high M&A failure rate.

Conclusion

In this discussion, we have attempted to understand some key M&A dynamics related to M&A motivation, target identification, and the prominent causes for a high M&A failure rate.

M&As do not represent the only transaction type that has a high failure rate. For instance, most startup businesses also fail. As we have seen in this discussion, the factors which are known to contribute to M&A success or failure are based on the human judgment which will always be prone to errors. This combined with the complexities of deeply rooted vested interests, conflicting objectives, information asymmetry, and the urge for radical experimentation & innovating business models will perhaps continue to contribute to a high failure rate with M&A transactions.

We have tried to establish in this discussion, that there are multiple factors that define M&A success. A company’s M&A strategy should first and foremost be based on a well-thought-out growth strategy, i.e., M&A is not the only means to a company’s growth, and the choice of M&A as a growth tool (as distinct from organic growth and greenfield investments) must in aligned with the assessment of a company’s core strength and the opportunities and threats that it faces.

Once the company has decided on M&A as its growth methodology, its target identification program must be made to maximize the chances of success. As we have pointed out in the discussion, mergers with related and complimenting businesses, stand a greater chance of success than unrelated businesses. Similarly, horizontal expansion is generally more successful than vertical integration. As we move away from this relatedness, the chances of success continue to recede, until it reaches as low as 10-15% with extreme diversification i.e., radical experimentation with the company’s business mix and model.

We have also discussed that the relative size of the target firms is also an important determinant of M&A success i.e., a relatively smaller target is more likely to lead to a successful merger than otherwise. Similarly, targets in a similar geographical market as the acquirer drive a higher success rate than targets located in distant foreign locations.

We also touched upon the circumstances where diversification could be the only possible or the best course of action. However, generally speaking, diversification alone as an M&A motivation could very well destroy value for reasons including difficulties with right pricing and then assimilating dissimilar businesses. Diversification for wrong reasons could also very well destroy the core business of the acquiring company.

We concluded our discussion by looking at the major causes for a high M&A failure rate and stressed the impact of merger wave phases which generally reduce the chances of success as they progress.??