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Mergers – Strategy @ Risk

Strategy @ Risk

Tag: Mergers

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

[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.

14/12/2011
What is the correct company value?
Nobel Prize winner in Economics, Milton Friedman, has said; “the only concept/theory which has gained universal acceptance by economists is that the value of an asset is determined by the expected benefits it will generate”.

Value is not the same as price. Price is what the market is willing to pay. Even if the value is high, most want to pay as little as possible. One basic relationship will be the investor’s demand for return on capital – investor’s expected return rate. There will always be alternative investments, and in a free market, investor will compare the investment alternatives attractiveness against his demand for return on invested capital. If the expected return on invested capital exceeds the investments future capital proceeds, the investment is considered less attractive.

One critical issue is therefore to estimate and fix the correct company value that reflects the real values in the company. In its simplest form this can be achieved through:

Budget a simple cash flow for the forecast period with fixed interest cost throughout the period, and ad the value to the booked balance.

This evaluation will be an indicator, but implies a series of simplifications that can distort the reality considerably. For instance, real balance value differs generally from book value. Proceeds/dividends are paid out according to legislation; also the level of debt will normally vary throughout the prognosis period. These are some factors that suggest that the mentioned premises opens for the possibility of substantial deviation compared to an integral and detailed evaluation of the company’s real values.

A more correct value can be provided through:
- Correcting the opening balance, forecast and budget operations, estimate complete result and balance sheets for the whole forecast period. Incorporate market weighted average cost of capital when discounting.
The last method is considerably more demanding, but will give an evaluation result that can be tested and that also can take into consideration qualitative values that implicitly are part of the forecast.
The result is then used as input in a risk analysis such that the probability distribution for the value of the chosen evaluation method will appear. With this method a more correct picture will appear of what the expected value is given the set of assumption and input.

The better the value is explained, the more likely it is that the price will be “right”.

The chart below illustrates the method.
15/02/2009
The Probability of Gain and Loss

Every item written into a firm’s profit and loss account and its balance sheet is a stochastic variable with a probability distribution derived from probability distributions for each factor of production. Using this approach we are able to derive a probability distribution for any measure used in valuing companies and in evaluating strategic investment decisions. Indeed, using this evaluation approach we are able to calculate expected gain, loss and their probability when investing in a company where the capitalized value (price) is known.

For a closer study, please download Corporate-risk-analysis.

The Probability Distribution for the Value of Equity

The simulation creates frequency and cumulative probability distributions as shown in the figure below.

We can use the information contained in the figure to calculate the risk of investing in the company for different levels of the company’s market capitalization. The expected value of the company is 10.35 read from the intersection between probability curve and a line drawn from the 50% probability point on the left Y-axis.

The Probability Distribution for Gain and Loss

The shape of the probability curve provides concise information concerning uncertainty in calculating expected values of equity. Uncertainty is reduced the steeper the probability curve, whereas the flatter the curve so uncertainty is more evident. The figures below depicts the value of this type of information enabling calculation of expected gains or losses from investments in a company for differing levels of market capitalization.

We have calculated expected Gain or Loss as the difference between expected values of equity and the market capitalization; the ‘S’ curve in the graph shows this. The X-axis gives different levels of market capitalization; the right Y-axis gives the expected gain (loss) and the left y-axis the probability. Drawing a line from the 50% probability point to the probability curve and further to the right Y-axis point to the position where the expected gain (loss) is zero. At this point there is a 50/50 chance of realising or loosing money through investing in the company capitalized at 10.35, which is exactly the expected value of the company’s equity.

To the left of this point is the investment area. The green lines indicate a situation where the company is capitalized at 5.00 indicating an expected gain of 5.35 or more with a probability of 59% (100%-41%).

The figure to the right describes a situation where a company is capitalized above the expected value.

To the right is the speculative area where an industrial investor, with perhaps synergistic possibilities, could reasonably argue a valid case when paying a price higher than expected value. The red line in the figure indicates a situation where the company is capitalized at 25.00 – giving a loss of 14.65 or more with 78% probability.

To a financial investor it is obviously the left part – the investment area – that is of interest. It is this area that expected gain is higher than expected loss.

11/02/2009
Risk, price and value
This entry is part 3 of 4 in the series A short presentation of S@R

Having arrived at the probability distribution for the value of equity (see full story) we are able to calculate expected gain, loss and their probability when investing in a company where the capitalized value (price) is known. (see “The Probability of Gain and Loss”)

In the figure below we have illustrated the investment and speculative area. The investment area comprice the part of the cumulative probability distribution below 50%.

The speculative area is the area above 50%. The expected value is given at the 50% probability point (stapled line). The literature advices, and successful investors insists, on having a safety margin (discount) of at least 20% between expected value (intrinsic value) and the market price, as shown by the yellow area in the figure below. Graham and Dodd in Security Analysis introduced the concept of a margin of safety in 1934.

In a stochastic framework as ours it is better to set the safety margin at one of the percentiles or quartiles giving directly the value of the safety margin. A fixed percentage safety margin will always give a different probability for gain (loss), depending on the shape of the cumulative probability distribution.

An investor having a portfolio of stocks should thus use percentiles as a margin – having the same probability for gain (loss) throughout the portfolio. In the case below a 20% safety margin coincide with the first quartile, – giving a 25% probability for loss and 75% probability for gain. The expected value of the company is 1.452 the first quartile is 1.160 giving an exepcted gain of 292 or more with 75% probability (dotted lines).

We know that the total risk of any individual asset is the sum of the systematic and unsystematic risk. When computing the figure above we have used the company’s appropriate beta to account for the systematic risk (in calculating WACC). The unsystematic risk is given by the variance in the figure above.

In a well-diversified portfolio the expected value of the unsystematic return is assumed to be zero. When investing in a single asset we should be looking for assets with a high unsystematic return. In our context companies with a capitalized value below the percentile set as limit of the safety margin.

References
1. Security Analysis: The Classic 1934 Edition by Benjamin Graham, David L. Dodd. October 1, 1996, McGraw-Hill Professional Publishing; ISBN: 0070244960
2. and an interesting webiste The Graham-Buffett Teaching Endowment
16/02/2008