The Use of M&A Transactions in Bankruptcy Valuations Reasons Why Acquirers Overpay Part II
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<h3>Reasons Why Corporate Acquirers Often Overpay for Mergers/Acquisitions</h3>
<p>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.
</p><p>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.
</p><p><i>Reason 1. Industry-wide consolidation pressures motivate many overpriced M&A
transactions.</i> 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.
</p><p><i>Reason 2. Stock market pricing pressures motivate many overpriced M&A
transactions.</i> 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.
</p><p><i>Reason 3. Buyer
company management often expects significant post-merger synergies and
economies of scale. </i>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.
</p><p><i>Reason
4. Corporate M&A analysts have to justify their existence to their buyer
corporation employers.</i> 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.
</p><p><i>Reason
5. Buyer companies set their M&A deal hurdle rates independent
from—and below—their actual cost of capital (WACC).</i> 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.
</p><p><i>Reason
6. Buyer management often believes that it will be more operationally efficient
in running the target company than seller management was.</i> 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.
</p><p><i>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.</i> 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.
</p><p><i>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.</i>
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.
</p><p><i>Reason
9. Both buyers and sellers often prepare unrealistically optimistic projections
regarding target company results of operations.</i> 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 (<i>e.g.,</i> in the late 1990s). In such periods, many M&A
transactions are closed at excessive prices.
</p><p><i>Reason
10. Buyer management often only relies on one valuation approach in the
transaction pricing analysis. </i>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.
</p><h3>Summary and Conclusion</h3>
<p>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.
</p><p>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.
</p><p>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.
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