Mega-Mergers: a lot can go wrong
Last week, HP recognized its latest acquisition failure in the form of an $8.8 billion write-off of its $9.7 billion acquisition of the British software company, Autonomy. In the wake of this mega-deal’s mega-bust, we at mergers.com wondered why big deals often seem to go so wrong. Obviously, the HP deal had to include a major element of fraud for Autonomy to have been overvalued by almost 1,000%, but the fact that large M&A deals show a convincing trend of overvaluation make low to mid-market M&A deals far more appealing.
Anyone who wishes to understand and be involved in the M&A industry should grasp the complexity of the valuation process, and more importantly, why overvaluation is so frequent. The following are some of the main reasons for companies to be overvalued.
While this is not the main reason for companies to be overvalued it is important to note that fraud is entirely relevant. The incentive is extraordinary for stakeholders to solicit the highest price possible in a deal. There is also ample room for oversight with so many moving pieces in a huge deal. It’s hard to believe that there was no fraud involved in the Autonomy acquisition for the valuation to be so far off the mark. It will be interesting to see the results of the investigation into the Autonomy deal because there were extensive audits by Deloitte and KPMG, not to mention the due diligence of the investment banks and HP itself. Fraud is the most obvious way that a company can be overvalued, but even with the best intentions, many deals go south.
While major M&A deals use a combination of valuation methods, the outcomes are often dependent on a plethora of assumptions. The main valuation methodologies are: (i) The comparable company analysis, where the value is determined by comparison to comparable companies; (ii) the discounted cash flow analysis, where the value is based on the present value of future cash flows; and (iii) the Precedent Transactions method, where the price is determined based on past transactions.
The latter method is probably the most susceptible to overvaluation due to the implementation of a control premium to reach a final price. The premium is the amount the buyer is willing to pay greater than the current market price of that company, and is often based on previous transactions that were overvalued in their own day. This premium is justified by the subsequent synergies that will result from the merger/acquisition, but many are skeptical about the ability of a mega-merger to realize synergies in an efficient manner.
The discounted cash flow model is highly sensitive to changes in assumptions because it relies on a multitude of factors, from Revenue growth, to Cost of Goods Sold, various timings, and much more. There is also a tendency for projections to be overly optimistic. This is fueled by not only by the target company wanting to look appealing, but the acquiring company also wanting to feel optimistic about their new business unit’s prospects.
The comparable company methodology is good for determining whether the current market price is over or undervalued compared to competitors, but also relies on various assumptions for consolidating various metrics to reach a final price. Regardless of which method dominates the valuation, each has its vulnerability to overvaluation, and when the decision-makers get emotional and eager to make the deal, those vulnerabilities are forgotten.
Mergers can absolutely lead to synergies that increase the value of each company, the classic example: 2 + 2 = 5. There is a lot to be said about economies of scale, resource integration, production efficiency and other synergies that can be reached, but these efficiencies are worthless if the company sets disproportionate expectations. Warren Buffett says that anything can be a good investment, “at the right price.” In an M&A transaction, most parties want the price to be high, the target obviously wants a high price, the Investment Bankers work on commission, and the acquirers, can often be too impatient to get the deal done. They have demanding shareholders who want progress and synergies, not to mention the prestige of executing a major deal. In the end, their fiduciary duty becomes a convoluted picture of conservative company strategy vs. making massive acquisitions and bold, awe-inspiring decisions.
Don’t get too cynical; massive, multi-billion dollar M&A deals aren’t all bad, they are just highly vulnerable to error, unsurprising considering all of those zeros. That is why so much money goes into the execution of M&A transactions. In a perfect world, slow deliberation, and transparent communication can lead to great M&A outcomes. Unfortunately for HP, this is not a perfect world.
by Jim Kerrigan