The Use of M&A Transactions in Bankruptcy Valuations Reasons Why Acquirers Overpay Part II

The Use of M&A Transactions in Bankruptcy Valuations Reasons Why Acquirers Overpay Part II

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Reasons Why Corporate Acquirers Often Overpay for Mergers/Acquisitions

The following discussion presents a list of 10 common reasons why corporate acquirers pay too much for M&A targets. For purposes of this list, "pay too much" is defined as (1) pay a total consideration greater than the target company investment/acquisition value to the buyer, given the target's expected economic benefits to the buyer, or (2) pay a total consideration that will yield an investment IRR that is lower than the buyer's cost of capital/WACC.

This list is presented as a "top 10" list of reasons. This list is not comprehensive; there are many possible reasons why specific buyers pay too much, given the facts and circumstances of a particular transaction. This list is not presented in order of frequency or priority. It represents 10 common reasons why buyers pay too much, based on long-term observations of hundreds of publicly disclosed M&A transactions in dozens of industries.

Reason 1. Industry-wide consolidation pressures motivate many overpriced M&A transactions. Buyer management perceives (correctly) that competitors are making acquisitions. It may appear that only the largest competitors will survive after the industry consolidation. So buyer management perceives (incorrectly) that it needs to make acquisitions—even overpriced acquisitions—in order to be one of the survivors in the industry.

Reason 2. Stock market pricing pressures motivate many overpriced M&A transactions. The stock market often (although not without exception) responds favorably to M&A announcements. This is because such announcements generally indicate growth, expansion and investment at the buyer company. Such announcements are often accompanied by buyer-management predictions of post-deal synergies, economies of scale, market dominance and other economic benefits. So, unless the deal is so overpriced as to be obvious to the market, the immediate effect of the buyer managements announcement of a deal is a higher buyer stock price.

Reason 3. Buyer company management often expects significant post-merger synergies and economies of scale. Based on these projections of post-merger economic income, buyer management does not believe it is overpaying for the target. However, the synergistic expectations and the corresponding financial projections often turn out to be unsupported, unfounded and inflated. Compounding these unrealistically optimistic expectations, buyer management often underestimates post-merger integration problems and related costs.

Reason 4. Corporate M&A analysts have to justify their existence to their buyer corporation employers. This includes "analysts" at all levels—from staff financial analysts to the most senior finance/corporate development executives. To prove their worth to the buyer (or to the board, stockholders, etc.), these analysts perceive that they have to find and consummate transactions. In order to consummate transactions, the analysts are willing to recommend/pay inflated prices for targets. In the corporate hierarchy, M&A analysts want to close deals to impress senior management. Senior management wants to impress the board. And boards seem to be impressed with managements that can get deals done.

Reason 5. Buyer companies set their M&A deal hurdle rates independent from—and below—their actual cost of capital (WACC). For example, buyer company management may decide on an M&A investment hurdle rate (IRR) of 15 percent. It may perform considerable competitive analyses and conduct extensive meetings before selecting this hurdle rate. If the hurdle rate is selected independent of the buyer's cost of capital, then the selected hurdle rate will be inappropriate for M&A pricing purposes. For example, if this buyer's actual WACC is 18 percent, and if management selected 15 percent as the M&A hurdle rate, then the buyer may consistently overpay for transactions.

Reason 6. Buyer management often believes that it will be more operationally efficient in running the target company than seller management was. As a related issue, buyer management often believes that it can achieve a lower cost of capital than seller management could. Based on these expectations, buyer management does not perceive that it is overpaying for the target company. However, the seller management often is not inefficient. In fact, the seller management may be operating the target company as efficiently (and with the lowest cost of capital) as possible, given the target's industry and competitive position. Such ego-based, unreasonable expectations can cause buyers to overpay.

Reason 7. Buyer management often does not perform sufficient due diligence procedures in order to uncover all of the target company contingent liabilities, operational problems, obsolescence issues or other company-specific risk factors. Often, the deal is announced before the buyer management has completed a rigorous due diligence investigation. Even if the post-announcement due diligence reveals risk factors that should cause the buyer to re-think the transaction, the buyer management is often too emotionally (or professionally) committed to the transaction to call off the deal.

Reason 8. Even when buyer analysts identify target company problems during the due diligence investigation, buyer management often believes that it can "fix" the problem post-closing. This is often a case of buyer ego winning out over buyer judgment. Typically, if the target company problem was easily solvable, seller management would have implemented a solution. Instead, what often happens is that buyer management inherits the seller management problems.

Reason 9. Both buyers and sellers often prepare unrealistically optimistic projections regarding target company results of operations. These optimistic projections, then, become the basis for the transaction pricing. While seller management projections are typically expected to be biased, buyer management projections may be even more optimistic. The typical (but typically erroneous) assumption of many M&A analysts is that the future will be better than the past. M&A analysts may misread market/industry/economic conditions in the preparation of overly optimistic projections. This often occurs at/near the top of a business cycle (e.g., in the late 1990s). In such periods, many M&A transactions are closed at excessive prices.

Reason 10. Buyer management often only relies on one valuation approach in the transaction pricing analysis. While several analytical methods may be used in the same approach, buyers often rely exclusively on the income approach to price the offer. Many buyers give little or no weight to market approach valuation methods in the transaction pricing analysis. In addition, most buyers do not even consider asset-based approach valuation methods in the M&A pricing. Accordingly, buyer management forgoes the opportunity for alternative valuation approaches (1) to provide confirmatory pricing evidence or (2) to identify an overpricing situation.

Summary and Conclusion

Corporate acquirers sometimes pay too much for M&A transactions. There are objective corporate finance guidelines to determine (1) what price constitutes a reasonable (financially sound) transaction price and (2) what price qualifies as an excessive purchase price. These objective financial analysis benchmarks were discussed above. There are numerous negative economic effects to a corporate acquirer for paying too much for an M&A transaction. Ten of the common negative implications were described above.

There are numerous reasons why corporate acquirers pay too much for M&A transactions. A "top 10" list of common reasons was presented. In order to avoid the significant economic detriments associated with overpayment, M&A analysts, buyer managements and buyer boards should carefully consider these common reasons why acquirers pay too much when pricing acquisitive transactions.

Parties to a bankruptcy often have to estimate the fair market value of a business or business interest. Analysts should carefully consider all transactional data before applying market approach valuation methods. If the transactional data do not reflect fair market value prices, then the data may not be relevant for bankruptcy valuation purposes.

Journal Date: 
Wednesday, October 1, 2003