The data is in: Acquisitions destroy value. Right? Well, that is what the well-publicized averages say about large transactions. And that is where the problems in applying reason to merger studies begin. In reality, no company manages an "on-average" merger, and most deals are too small to be included in the typical merger study. That said, my study of 302 major transactions from the recent merger boom, published in BusinessWeek, found a 40-60 split between winners and losers, with a slightly negative average peer- adjusted return to acquirers - hardly a disaster story.
But here we are. With an extra push from the incredible collapse of previously celebrated serial acquirers such as WorldCom Inc., Conseco Inc. and Tyco International Ltd., the pendulum has rapidly swung to a far more conservative view of M&A as a growth tool than existed just a few years ago. This is especially true in the boardroom, where Sarbanes-Oxley has thrust boards into the spotlight and recent accounting rules (i.e., FAS 142 impairment tests) are shining a bright light on poor transactions that were approved by supposedly informed directors. Executives who advocate acquisitions may now encounter risk-averse boards with the view that investors prefer organic growth. Indeed, in many boardrooms there is a new "just say no" defense - but for acquirers.
Is there any truth to the view that organic growth results in better shareholder performance than acquisitive growth? And how does a corporate dealmaker have an informed discussion with an unduly conservative board or, on the other hand, with an overzealous CEO who wants to do something he considers "strategic" at any price? We know there are plenty of winners and losers in organic growth investments as well as in acquisitions. First principles tell us that companies with good shareholder performance are those that can grow at returns on invested capital higher than the cost of capital. But somehow recent debates on growth options have become labels-based - that is, whether organic growth is better than acquisitive growth. That's the wrong question. The right one is this: How effectively will the corporate development tool under consideration grow shareholder value over the long term?
To bring clarity to the issue, I examined more than 900 companies from the Standard & Poor's 1,500 for which continuous data were available for the 12-year period 1990-2001. Average annual relative total shareholder returns, or RTSR - capital appreciation plus dividends, less returns to industry peers - were calculated for each company. I then separated companies into three growth-strategy cohorts based on their level of material M&A activity over the 12 years: organic growers - no significant transactions; highly acquisitive - significant transactions in at least six of the 12 years; and moderately acquisitive - significant transactions in at least one but less than six of the 12 years.
The chart illustrates the RTSR performance of the three growth strategies. One thing is immediately clear: There is no systematic investor bias against or in favor of companies that have used acquisitions as part of a corporate development program.
| It's not the means that matters-it's the quality |
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As the bar charts show, for companies in the middle three quintiles of the study, different growth strategies yield rather similar results. The tables zoom in on what's happening, on average, among the top and bottom performers (the first and fifth quintiles) for each strategy.
Conclusion: valuable growth isn't a function of a particular strategy, but of return on invested capital. |
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RTSR is relative total shareholder return
Comparison is to S&P 1,500 economic sector, 1990-2001 |
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1st quintile |
5th quintile |
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1st quintile |
5th quintile |
|
1st quintile |
5th quintile |
| RTSR |
10.4% |
-8.5% |
11.8% |
-9.5% |
14.6% |
-9.5% |
| Rev. Growth |
15.7 |
7.2 |
16.0 |
6.3 |
23.1 |
8.6 |
| ROIC |
12.6 |
5.1 |
11.7 |
9.0 |
14.8 |
10.4 |
| Change in ROIC |
2.8 |
-2.0 |
4.1 |
-1.0 |
5.6 |
-0.9 |
All data in average annual percentages for 1990-2001
ROIC is return on invested capital
Source: Compustat |
The major findings can be summarized as follows:
1. No matter what the growth strategy, it is tough to beat peers. The median annual RTSR for each category is close to zero. Moreover, organic growers appear just as likely to underperform acquisitive growers, based on percentages, as acquisitive growers are to underperform organic growers. So much for the inherent superiority of one approach over the other.
2. Acquisitive growth strategies have a higher variance in returns. This reflects the fact that acquisitions on balance have more inherent risk. Payment is made up front, most often at a premium, versus staged investments in organic strategies where funding can be diverted to better projects. And acquisitions have high exit costs because it is extremely difficult to unwind them when integration goes badly or when they were not a good idea in the first place.
3. Most important, across each growth strategy, the best performers have dramatically higher revenue-growth rates and returns on investment than the bottom performers. Further, top performers show a significant positive annual improvement in return on invested capital over the 12-year period, whereas the bottom performers show a decline. The chart shows this comparison for the top 20% and bottom 20% of RTSR performers in each of the three growth strategies. This finding is far more important than any average because it goes to the heart of what strategy is all about - beating competitors and rewarding investors.
The upshot: Companies that achieve superior long-run returns for their shareholders don't worry whether they are growing organically or through acquisitions per se. They focus on the ongoing search for opportunities that allow them to grow at the highest returns on capital.
So how is this meaningful for corporate dealmakers developing acquisition proposals and preparing for discussions with the board? First, and most obvious, the proposal must show the investment will yield a return above the cost of capital - and higher than what was already expected - or there will be no way to justify a premium. Second, because a positive spread between returns on investment and cost of capital reflects competitive advantage, proposals must describe in detail how customers will get more of what they want and cannot get anywhere else, in ways not easily replicated by competitors. Third, proposals must include detail regarding how the deal will be integrated - an operating model of what will change to support the business case. In fact, this is where the distinction between organic growth and acquisitive growth rapidly fades. When an acquirer makes an acquisition and executes operational and organizational changes in the acquired company to improve performance (revenues or costs), these changes - the changes that create value - are really organic.
Perhaps most important, executives must show that the opportunity at hand came from a process that compared this transaction against other growth options. A successful corporate development process allows a company to avoid bad opportunities and find good ones at the same time. It is the only credible way to ensure that the business strategy is driving the ongoing search for the best alternatives, and that the approach isn't just a reactive one, chasing an opportunity that became available and working backward.
Ultimately, M&A proposals should be judged by a simple standard. If this deal were brought to the market, would it give investors good reasons to buy your shares, or to sell them? This is the way to talk to your board. - Mark Sirower
Mark L. Sirower is a managing director in the Transaction Services' Strategy Group of PricewaterhouseCoopers in New York where he leads the M&A strategy practice. He is a visiting professor at New York University and author of "The Synergy Trap: How Companies Lose the Acquisition Game" (Free Press).
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