# M&A: When two plus two is five or three or …

When two plus two is five (Orwell, 1949)

## Introduction

Mergers & Acquisitions (M&A) is a way for companies to expand rapidly and much faster than organic growth – that is coming from existing businesses – would have allowed. M&A’s have for decades been a trillion-dollar business, but empirical studies reports that a significant proportion must be considered as failures.

The conventional wisdom – is that the majority of deals fail to add shareholder value to the acquiring company. According to this research, only 30-50% of deals are considered to be successful (See Bruner, 2002).

If most deals fail, why do companies keep doing them? Is it because they think the odds won’t apply to them, or are executives more concerned with extending its influence and company growth (empire building) and not with increasing their shareholder (s) value?

Many writers argue that these are the main reasons driving the M&A activities, with the implication that executives are basically greedy (because their compensation is often tied to the size of the company) – or incompetent.

To be able to create shareholder value the M&A must give rise to some forms of synergy. Synergy is the ability of the merged companies to generate higher shareholder value (wealth) than the standalone entities. That is; that the whole will be greater than the sum it’s of parts.

For many of the observed M&A’s however, the opposite have been the truth – value have been destroyed; the whole have turned out to be less than the sum of its parts (dysergy).

“When asked to name just one big merger that had lived up to expectations, Leon Cooperman, former co-chairman of Goldman Sachs’ Investment Policy Committee, answered: I’m sure there are success stories out there, but at this moment I draw a blank.” (Sirower, 1997)

The “apparent” M&A failures have also been attributed to both methodological and measurement problems, stating that evidence – as cost saving or revenue enhancement brought by the M&A is difficult to obtain after the fact. This might also apply to some of the success stories.

What is surprising in most (all?) of the studies of M&A success and failures is the lack understanding of the stochastic nature of business activities. For any company it is impossible to estimate with certainty its equity value, the best we can do is to estimate a range of values and the probability that the true value will fall inside this range. The merger two companies amplify this, and the discussion of possible synergies or dysergies can only be understood in the context of randomness (stochasticity)^{1}.

[tube] http://www.youtube.com/watch?v=AUSKTk9ENzg, 400,300 [/tube]

## The M&A cases

Let’s assume that we have two companies A and B that are proposed merged. We have the distribution for each company’s equity value (shareholders value) for both companies and we can calculate the equity distribution for the merged company. Company A’s value is estimated to be in the range of 0 to 150M with expected value 90M. Company B’s value is estimated to be in the range of -40 to 200M with expected value 140M. (See figure below)

If we merge the two companies assuming no synergy or dysergy we get the value (shareholder) distribution shown by the green curve in the figure. The merged company will have a value in the range of 65 to 321M, with an expected value of 230M. Since there is no synergy/dysergy no value have been created or destroyed by the merger.

For company B no value would be added in the merger if A was bought at a price equal to or higher than the expected value of the company. If it was bought at a price less than expected value, then there is a probability that the wealth of the shareholders of company B will increase. But even then it is not with certainty. All increase of wealth to the shareholders of company B will be at the expenses of the shareholders of company A and vice versa.

### Case 1

If we assume that there is a “connection” between the companies, such that an increase in one of the company’s revenues also will increase the revenues in the other, we will have a synergy that can be exploited.

This situation is depicted in the figure below. The green curve gives the case with no synergy and the blue the case described above. The difference between them is the synergies created by the merger. The synergy at the dotted line is the synergy we can expect, but it might turn out to be higher if revenues is high and even negative (dysergy) when revenues is low.

If we produce a frequency diagram of the sizes of the possible synergies it will look as the diagram below. Have in mind that the average synergy value is not the value we would expect to find, but the average of all possible synergy values.

### Case 2

If we assume that the “connection” between the companies is such that a reduction in one of the company’s revenues streams will reduce the total production costs, we again have a synergy that can be exploited.

This situation is depicted in the figure below. The green curve gives the case with no synergy and the red the case described above. The difference between them is again the synergies created by the merger. The synergy at the dotted line is the synergy we can expect, but it might turn out to be higher if revenues is lower and even negative (dysergy) when revenues is high.

In this case, the merger acts as a hedge against revenue losses at the cost of parts of the upside created by the merger. This should not deter the participants from a merger since there is only a 30 % probability that this will happen.

The graph above again gives the frequency diagram for the sizes of the possible synergies. Have in mind that the average synergy value is not the value we would expect to find, but the average of all possible synergy values.

## Conclusion

The elusiveness of synergies in many M&A cases can be explained by the natural randomness in business activities. The fact that a merger can give rise to large synergies does not guarantee that it will occur, only that there is a probability that it will occur. Spread sheet exercises in valuation can lead to disaster if the stochastic nature of the involved companies is not taken into account. AND basing the pricing of the M&A candidate on expected synergies is pure foolishness.

**References**

Bruner, Robert F. (2002), Does M&A Pay? A Survey of Evidence for the Decision-Maker. Journal of Applied Finance, Vol. 12, No. 1. Available at SSRN: http://ssrn.com/abstract=485884

Orwell, George (1949). *Nineteen Eighty-Four. A novel*. London: Secker & Warburg.

The whole is more than the sum of its parts. Aristotle, *Metaphysica*

Sirower, M. (1997) The Synergy Trap: How Companies Lose the Acquisition Game. New York. The Free Press.

- See: the IFA.com – Probability Machine, Galton Board, Randomness and Fair Price Simulator, Quincunx at http://www.youtube.com/watch?v=AUSKTk9ENzg [↩]