In an environment marked by intense global competition and industry disruption, successful mergers and acquisitions (M&A) are increasingly important to the growth and profitability of many companies.

Yet research shows most mergers disappoint. Over the decades, multiple studies have shown that mergers and acquisitions fail to generate the anticipated synergies, and many actually destroy value instead of creating it. In other words, a significant percentage of M&A causes two plus two to equal three instead of five.

Those are the views of Nuno Fernandes, professor of finance at Barcelona’s IESE Business School and the author of The Value Killers: How Mergers and Acquisitions Cost Companies Billions – And How To Prevent It .

So why do companies continue to chase M&A deals and how can they improve the odds of adding rather than destroying value?

BIGGER DOESN’T MEAN BETTER

As professor Fernandes explains, the fact most M&A deals fail to create value is not random or down to bad luck but due to a series of failures starting at the pre-acquisition phase.

In an article for the Harvard Law School Forum on Corporate Governance, he sets out the golden rules which companies need to stick to if they aren’t going to destroy value.

First, companies should never rely on investment bankers for valuation because ‘bankers are always on the side of the deal, not the company’. In other words, the bigger the deal the bigger the fees.

Having an in-house valuation expert or business development group is a good start, but there still needs to be a vast amount of planning and attention to detail before a deal even comes to the table, looking at how it stacks up in terms of cash-flows, both before and after, and what is the right multiple.

While there may be good commercial reasons to do a deal – improving manufacturing or distribution and reducing unit costs, for instance – there are just as many bad reasons.

‘Strategic deals’ in particular are dangerous as they usually amount to little more than empire-building or egomania on the part of the acquiring chief executive.

The most obvious reason why deals don’t tend to add value is price – too many companies over-pay for the target company’s assets even if the projected synergies do eventually materialise.

‘This seems both simple and obvious, but the reality is that most companies overpay. In fact, one could make an argument that, directly or indirectly, overpayment is the cause of the high M&A failure rate,’ says Fernandes.

HOW TO MAKE M&A A SUCCESS

Instead of overpaying, companies need to think like financial investors and set a price limit meaning chief executives must be prepared to say no and walk away rather than do a deal at a poor price.

‘Successful acquirers develop models to identify the pros and cons of a deal, they avoid bidding wars, they exercise the discipline to walk away from bad deals, and they establish processes to keep CEO emotions in check. Overconfidence is a notorious value killer, and the board of directors has a strong role to play here,’ advises Fernandes.

Companies should have a continuous process linking the pre-deal phase with the transaction and post-deal phase, assigning clear responsibilities and accountability to the executives or teams in charge of planning, negotiating and implementing the acquisition.

‘Too often, the people making promises about merger synergies are not the same ones in charge of putting those synergies into place. Ideally, companies should assign the same team members to every phase of the transaction, including the post-merger integration,’ suggests Fernandes.

Linked to this, companies need to move fast and communicate effectively as the news that a company is in talks to be acquired can have a negative effect on employee morale and customer relationships.

‘Companies that communicate quickly, constantly and openly during a deal are better able to retain their focus and reduce uncertainty among customers and employees, especially the best employees of the target company. Because talent exodus is a big risk during most M&As, senior managers must be ready to answer the “What happens to me?” question before employees even ask it,’ is the advice.

Finally, all successful acquirers have the management capability not to get distracted or pulled away from their day-to-day operations so deals which result in chief executives and finance officers taking their eye off the ball are likely to end badly.

WHAT ABOUT ‘BOLT-ON’ DEALS?

Some of the most successful, highest-return businesses in the UK market are also serial acquirers, but their dealmaking doesn’t make the headlines.

Instead of ‘strategic’, or worse still ‘transformational’ acquisitions, they seek out attractive smaller businesses which they can comfortably absorb to increase their geographical footprint or their commercial offering to clients, complementing their organic growth and making them more of a ‘one-stop shop’.

Take equipment hire firm Ashtead (AHT), which in the year to April 2022 posted 22% growth in rental revenue helped by $2.4 billion of investments in its business and $1.3 billion spent on 25 small acquisitions.

In the year to April 2023, the firm reported another 22% increase in rental revenue, helped this time by $3.8 billion of capital invested in the business and $1.1 billion spent on 50 small bolt-on acquisitions.

All these investments are funded from operating cash flow, and they allow the company to open hundreds of new sites in North America to, in the words of chief executive Brendan Horgan, ‘take advantage of the substantial structural growth opportunities that we see for the business’.

Alternatively, look at ‘global specialist’ acquirer Halma (HLMA), which in the year to March 2022 posted a 16% increase in revenue and a record profit for the 19th consecutive year thanks to strong organic growth, spending on R&D (research and development) and 13 small acquisitions for a total of £164 million.

In the year to March 2023, Halma reported a 21% increase in revenue and its 20th consecutive year of record profit due once again to double-digit organic growth, another hike in R&D spending and seven medium-sized acquisitions worth just under £400 million to complement its existing businesses.

Or take the example of video games service company Keywords Studios (KWS:AIM), which saw revenue rise by 37% in the year to December 2022 driven by 22% underlying growth together with five ‘high-quality’ acquisitions, delivering against its strategy of extending its reach and capabilities while scaling its technology offering.

For the year just ended, Keywords reported revenue growth may have slowed to 17% on a constant currency basis due to the Hollywood strikes but the firm still enjoyed nearly 10% underlying growth and made five more ‘high-quality’ bolt-on acquisitions.

ACQUISITION-DRIVEN COMPOUNDERS

The appeal of these high-quality ‘acquisition-driven compounders’ hasn’t gone unnoticed by professional investors.

Scandinavian wealth management firm REQ specialises in running ultra-long-term, concentrated equity funds focused on just such companies, including the three mentioned above.

The managers look for companies which:

• Are excellent at sourcing and closing frequent, small acquisitions in the private market at highly attractive multiples;
• Have strong cash flow generation, which in turn is reinvested at high returns on capital;
• Have management teams who are excellent capital allocators and often own a significant part of these companies;
• Have decentralised business models and offer exposure to a diverse array of small private companies spanning multiple end-markets;
• Have dual engines of profitable growth (organic and through acquisitions).

Acquisition-driven compounders, also known as ‘programmatic acquirers’, specialise in buying small, private niche businesses, frequently family-owned which enjoy a solid financial record and organic growth but typically lack the organic reinvestment opportunities to absorb the significant cash flow they produce.

Once these small, niche business have been acquired, the strong cash flows they generate can be reinvested to generate a higher return on capital than their cost of capital for an extended period.

At first glance, acquisition-driven compounders may seem confusing: ‘From a 30,000-foot view, what you see might look like a mess. The logical conclusion may be to embark on integration efforts as these businesses seem ripe for serious cost and sales synergies.’

However, a closer look at the highest-performing companies in the universe reveals a collection of decentralised and autonomous business units, each protecting its entrepreneurial independence.

‘Many of these businesses have distinct cultures, but they all thrive on ownership and autonomy enabled by decentralisation. Therefore, finding the right balance between decentralisation and integration represents an ongoing battle with temptations and difficult trade-offs,’ argue the managers.

THE WORST M&A DEALS IN HISTORY

The golden era of mega-takeovers was the late 1990s, when technology and telecom firms saw their valuations soar giving then the financial firepower to make all-share offers for their rivals.

The biggest and most ill-timed deal of all time has to be AOL-Time Warner, a $165 billion transaction announced in January 2000 just before the tech bubble burst.

The merged firm racked up almost $100 billion of losses in less than two years and the firms ultimately went their separate ways a decade later.

DISCLAIMER: The author of this article owns shares in Halma. 

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