This post was prompted by an article I stumbled across, describing a recent presentation by Aswath Damodaran. I found a version of this presentation here, though this version may well be a bit out of date. In it, he argues that there is clear evidence that acquisitions tend to destroy value for the shareholders of the acquiring business. I’ve heard this plenty of times before but haven’t thought much about the consequences for my own investments. On reflection this seems negligent. Base rates matter. I should really have a better idea of what the evidence actually says.

I haven’t taken the trouble to go through the histories of all the companies in my portfolio and watchlist, but it hasn’t taken me long to realise that only a small minority haven’t undertaken acquisitions in the last few years. On top of that, many of them have explicitly acquisitive business models, such as Micro Focus and Judges Scientific in my current portfolio.

I’ve tended to see these strategies as a positive rather than a red flag. As long as the acquisitions are complementary to the existing business, aren’t overvalued and carry low execution risk, an acquisitive strategy seems like it should be a decent way to generate growth, exploit synergies and in some cases reinforce a competitive advantage or diversify risk. But there are also clearly risks. There are plenty of examples where acquisitions have gone horribly wrong. While some are a good idea, others do not justify the risks involved. Before getting to the empirical evidence, I think it’s important to ask why businesses would tend to pursue the bad ideas over the good ones?

Why do businesses make bad acquisitions?

One part of the picture of pretty much every acquisition that goes wrong is that the acquirer overpaid. Valuation is difficult. It inherently requires speculation about the future and leaves a lot of room for more subjective judgment. Investors are prone to excessive pessimism about valuations during crashes and excessive optimism during bubbles. Executives deciding on acquisitions are probably subject to these same biases. Indeed M&A activity tends to follow the stock market cycle closely. Similar to investments more widely, acquisitions that take place earlier in the cycle tend to do better.

Life is made more difficult for the acquirer as it has less information about the prospects of the target compared to its current owner. The target has every incentive to exaggerate its current profitability or future potential. There are plenty of examples of acquirers being totally deceived by accounting shenanigans despite their best efforts at due diligence.

An acquiring business doesn’t just need to work out how much the target business is worth, but also how much premium is justified by the synergies or strategic benefits the acquisition is likely to generate. It’s all too easy to overestimate how significant synergies would be or underestimate how difficult they would be to achieve. It’s also easy to underweight the risk that the merger destroys valuable culture or ways of working, something I’ve experienced first hand.

Unfortunately the incentives of the managers and advisors involved in the decision-making are often to pursue acquisitions with less regard to the risks of shareholder value destruction. I’m sure ego often plays a role in this too. Having executives whose incentives are better aligned with lots of skin in the game seems particularly important if they are on the acquisition trail.

Overall there seem to be plenty of reasons why businesses might go for bad acquisitions, especially if good opportunities aren’t available. This doesn’t necessarily imply that acquisitions would tend to destroy value for acquirers on average but it does make it plausible.

The empirical evidence

It’s easy to come up with plenty of examples of either successful or unsuccessful acquisitions. What I really want to know is what happens on average and even more importantly whether certain types of acquisition are more likely to be successful than others. While I can’t really claim to have done a very thorough review, I’ve had a good rummage through the empirical evidence readily available online.

The studies most reported are one by KPMG and another by McKinsey from around the turn of the century. Both found that the majority of mergers destroyed value. I also came across a meta-analysis, which looked at the results of 33 previous empirical studies and found that just over half of acquisitions destroyed value. All of these studies looked at the impact of specific acquisitions on the acquiring business’s share price over the subsequent days and months.

However, I don’t think you can take these results at face value. What these studies actually show is more limited than the headline results would suggest. One issue is the time period the sample of mergers considered is taken from. The KPMG paper looks at the impact of acquisitions made between 1996 and 1998, a fairly narrow window at a late stage in the market cycle. This was probably not the best time to be making acquisitions (though they were becoming increasingly popular at the time). Some more recent studies, such as this one by Cass Business School, found that mergers do create value on average.

Another more important issue when interpreting the empirical evidence is with the counterfactual. What other options were available to the acquirer at the time? Businesses need to keep up with the competition and most will ultimately fail. It seems plausible that many of the companies that made the acquisitions that turned out badly did so because the alternative had even lower odds of success. Whether certain acquisitions turn out to be more successful than others may often have more to do with whether the acquirer is a high quality business than whether the acquisition decision itself is particularly inspired. It’s very hard to account for this empirically. One way in which academics have tried is to compare the outcomes of bids that succeed from those that fail – if acquisitions genuinely destroyed value then having a bid fail would tend to be a positive. This study finds otherwise, suggesting that acquisitions tend to add value, though there are obvious concerns about whether the sample of mergers considered is genuinely representative of the wider population. Other studies with a similar methodology have found the opposite result.

The more compelling empirical research I found didn’t try to look at whether specific acquisitions hurt share prices. Instead it took a broader look at how different types of growth strategy, with or without acquisitions, performed over the longer term. I found several studies that did this and some consistent results:

• One by Mckinsey categorised the 1000 largest world companies over the period 1999-2010 by different types of M&A strategy. It found that companies that used a programmatic strategy involving many small deals were most successful, significantly ahead of businesses that only pursued organic growth. Businesses that pursued occasional transformational deals did the worst. This study also looked at what kind of strategy did better in different sectors…
• One by Bain and another by ATKearney over a similar period also found that businesses that pursued an active M&A strategy did better than those that did not. It found the more frequent the M&A activity the better the performance, suggesting that greater experience and a deliberate strategy was better than opportunistic one.
• Finally this excellent paper by Michael Mauboussin on capital allocation in general had references to lots of other useful research telling a similar story i.e. systematic buy and build strategies have high success rates while occasional large transformational deals have low success rates.

The empirical evidence I’ve found on whether acquisitions destroy value in general is actually pretty mixed. If anything it suggests that acquisition decisions have got better over time and in recent years have tended to add value. More striking was the consistent finding that deliberate systematic strategies involving lots of acquisitions tend to add value while occasional transformational deals tend to destroy it. Seems pretty intuitive to me!