“I am a better investor because I am a businessman and a better businessman because I am an investor.” – Warren Buffett
During the course of a week, I spend a good amount of my free time reading books by great investors such as Ben Graham, Bruce Greenwald, and James Montier. But every so often, I feel it is important to dig deeper into other aspects of businesses, and will pick up a book that focuses on marketing or management; as an owner, I want to understand as much as possible about the business model of the corporations I’m invested in.
Recently, I was reading “Winning” by Jack Welch, the former CEO of General Electric (GE), and found a great section that is directly applicable to investors who want to assess management’s performance on key strategic decisions that are often a big step towards either value creation or destruction for shareholders: mergers and acquisitions.
As investors, it is important to keep an eye on managers and take the necessary action (whether it be activism or, more likely, selling your shares) when they are “empire building” for their own personal benefit, rather than investing for the sake of adding long term shareholder value.
As Jack Welch points out, plenty of the M&A pitfalls discussed below happen because of (what he calls) “deal heat”:
“I’m sure I don’t need to illustrate this phenomenon in gruesome detail; you see it every time a company is hungry to buy the pickings and the marketplace is relatively limited. In such situations, once an acquisition candidate is identified, the top people at the acquirer and their salivating investment bankers join together in a frenzy of panic, overreaching, and paranoia, which intensifies with every additional would-be-acquirer on the scene.”
That sounds like some of the M&A that we have seen in the past couple of years. Whether it be the Kraft (KFT)/Hershey (HSY) battle for Cadbury, or the more recent (and crazier) standoff between HP (HPQ) and Dell (DELL) for 3Par, management is far from immune to the pitfalls of M&A; once they become attached, all it takes is a little tweaking of the numbers (as needed) to justify higher and higher bids. As Jack Welch says, “when they [people] want something that someone else wants, all reason can disappear.”
As investors, we often need to dig in our evaluations of M&A activity; simply taking the CEO (who is paid to be optimistic about their business) at face value can be a risky strategy. Here is the list of the seven pitfalls listed by Jack Welch, which can be used by investors as a checklist to sniff out value destroying M&A:
Mergers of equals
This is similar to the well known entrepreneurial pitfall where people split ownership 50/50; at the end of day, someone needs to be in charge, and making the decisions. As he points out with the example of the DaimlerChrysler merger, “someone has to lead and someone has to follow, or both companies will end up standing still.”
Focusing on the strategic fit without assessing the cultural fit
While this is a harder assessment for outside investors to come to, there is one tool that I have found effective: listen for management to talk about the culture of a firm they are acquiring or have passed up on. Jay Fishman, the CEO of Travelers (TRV), mentioned on the last conference call that they passed on an acquisition because the corporate cultures wouldn’t blend well. As an investor, I love to hear this; better to sit back and wait rather than throw away capital on a long shot.
Reverse hostage situations
The third pitfall occurs when management wants to own a company so bad that they end up making too many concessions during negotiations. This is another situation that is difficult for investors to assess; as with most of these pitfalls, the best bet is to stick with managers that carefully assess M&A activity, and only do so when it is an attractive deal/fit.
Integrating too timidly
This is similar to the MOE situation discussed in the first pitfall; someone needs to be making the decisions and in charge of leading through the transformation. “If ninety days have passed after the deal is closed and people are still debating important matters of strategy and culture, you’ve been too timid. It’s time to act.”
Conqueror syndrome
Conqueror syndrome happens when the acquiring company takes over, and immediately puts its own managers in charge (due to familiarity). This undermines one of the key benefits of M&A: the chance to filter talent from a bigger pool of potential leaders. As Jack Welch puts it, “this is a competitive advantage that you cannot let pass.”
Paying too much
For investors, this is probably the pitfall that crosses their slate far too often. Look no further than the infamous Time Warner-AOL (TWX) merger; with promises of synergies and “convergence”, all notions of reason and valuation is out the window. For investors, this is where we can develop a realistic idea about management; listen to what they say about M&A on calls (the goals should be documented and checked on in the future), and make sure they aren’t paying ridiculous premiums for things like “synergy”.
Resistance (from the acquired)
The only pitfall that involves action from the acquired company is resistance; this is barely applicable for investors, who happily walk away with a 30-40% premium for their shares. For investors who plan on holding stock in the acquiring corporation, this relates to the issues in the second pitfall; beware of cultural clashes and struggles from employees (top to bottom) to become part of the new corporation.
While these pitfalls are more often applicable to managers rather than investors, it is important as a shareholder to keep tabs on the actions taken by top executives. As noted by Richard Schoenberg, an active researcher in the field of strategic management, managers of acquiring firms report that only 56% of their acquisitions can be considered successful against the objectives originally set. With that being said, M&A certainly has its place in business, and can be a great tool to develop “missing link” business strategies in the future (for example, PepsiCo’s (PEP) recent acquisition of Wimm-Bill-Dann, which CEO Indra Nooyi has said is a great business on its own, but also provides a source of technology to build out the value added dairy business globally). Just make sure that if management is going to choose to invest excess capital rather than give it back to the owners, they are doing it in a way with the greatest potential to add value back at an acceptable rate of return for shareholders in the future.
