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Now may be a good time to think of M&A

Now may be a good time to think of M&A

SOURCE: FT CORPORATE FINANCE PULL OUT: 25th June, Peter Thal Larsen

 

Now might not seem the best of times to be thinking about mergers and acquisitions. In a slowing economy where the full effects of the credit crisis have yet to be felt, most executives will probably feel they have other things to worry about than adding to their empires.

Yet in retrospect, 2008 may turn out to be the best period for deals for some time to come.

Conventional wisdom suggests the opposite. In an uncertain market, companies have a hard enough time predicting their own performance, let alone that of potential takeover targets.

Falling share prices mean that companies are often reluctant to issue new equity to finance a deal, while companies on the receiving end of a bid still have an inflated sense of their true value.

For those considering cash deals, the cost of borrowing has risen sharply.

What's more, executives should be cautious about mergers and acquisitions at the best of times.

As the academic studies consistently point out, most deals fail to create value for shareholders.

This is either because the bidder overpays, or because it botches the integration of the deal.

The first question for a board of directors presented with a possible takeover should be: what else could we do with the cash and the time of our top executives that this deal will consume?

A glance at the track record suggests that the worst deals are often those done at the height of a bull market.

Vodafone's acquisition of the rival mobile phone operator, Mannesmann; America Online's purchase of Time Warner; and Daimler's takeover of Chrysler of the US are all clear examples of deals that, while being widely hailed as visionary at the time they were struck, destroyed large amounts of shareholder value.

On the current evidence, last year's €71bn break-up bid for ABN Amro, the Dutch lender, may go down as the biggest M&A mistake of the current cycle.

By contrast, there is evidence that the better deals are those which are done after the cycle has turned.

A recent study by Towers Perrin, the consultancy, and Cass Business School in London found that companies that did deals in the year after the peak of a merger boom generated much better shareholder returns than those buying at the top of the cycle.

The authors of the study looked at more than 38,000 M&A transactions that were announced in the three-year periods before, during, and after the merger booms of 1988 and 1999, and the deals that were announced in 2004, 2005 and 2006.

They found that companies involved in deals done in the year before the peaks of 1988 and 1999 underperformed the market by 2 per cent in terms of shareholder return.

Those buying businesses in the peak year performed better, but still underperformed by 0.2 per cent.

But companies that announced transactions in the year after the top of the market outperformed, on average, by more than 5 per cent.

Interestingly, deals done in the run-up to 2007 - likely to be the peak of the current boom - have a better track record in terms of delivering value than in previous cycles. But it remains to be seen how these transactions measure up following the downturn.

At first glance, the findings of the study may seen counter-intuitive. But, on reflection, it is possible to see that they make sense. Transactions struck after the peak of a boom are less likely to be deals of a risky, mould-breaking variety.

At a time when markets are on their way down, deals are more likely to be conventional.

And it is those kinds of mergers, involving two rivals in the same industry, driven by the potential for cost-cutting, efficiencies of scale, and greater pricing power in the market, that generally have a better record of success.

Deals can also provide an opportunity to cut capacity in a slowing market.

Downturns also create opportunities. Companies that reached too far in the boom may find they are overstretched, lumbered by heavy debt burdens or the failure of previous deals.

Management teams may have lost the confidence of their investors. A change of management may lead to a different approach to strategy, involving the sale of parts or all of the business. It is at times such as these that companies can pick up bargains.

Of course, none of this adds up to an imperative to go out and pursue a deal. The situation will vary by industry, and depend on the position a company finds itself in.

Any transaction must pass the usual tests: the buyer must be confident it has understood what it is buying, and that it has done enough due diligence.

Executives must have a clear idea of how they are going to integrate the business, and what benefits the deal will bring. They must have built in a margin for error.

And, above all, the price and the financial structure of the deal must be right.

However, the central point is that a downturn is no excuse to stop thinking about transactions.

Companies with a clear, long-term view of their strategy can use opportunities such as these to pick up deals that may not have made sense a year or two earlier.

It may be more difficult to justify at a time when investors have lost their appetite for bold moves.

But there is a strong argument to be made that the best deals are done at a time when others are distracted. Executives should be prepared to make it.