In this "Jnet" series, we introduce current topics in the field of corporate M&A, revitalization and restructuring that are relevant to Japanese companies operating in the United States. In this issue, we feature a recent study on the factors that contribute to deal success.
The deal environment remained challenging in 2009. The dollar value of global deals fell 41 percent in the third quarter of 2009, from the third quarter of 2008 to $478 billion. It was the eighth consecutive quarter that the value of U.S. deals fell from a year earlier. It is no secret that the M&A market was negatively affected by several factors. In addition to a lack of financing options, acquirers and sellers were confronted with the problem of making realistic valuations in the face of rapidly declining revenues and uncertain consumer and business demand.
However, several large deals were announced, such as Pfizer’s US$68 billion acquisition of Wyeth. Certain industries, such as the financial sector, also showed some increasing activity. In addition, acquirers demonstrated an appetite for smaller deals and distressed assets.
When companies are under even more shareholder scrutiny than usual, it is important to examine the factors that are correlated with deal success, which we define in this study as an increase in shareholder value. In addition to more commonly examined factors, such as financing options, this study looks at less frequently examined factors, such as deal rationale. This white paper is a follow-up to one completed in 2007, in which we examined deals announced between 2000 and 2004. This study is based on an analysis of 460 worldwide corporate deals that were announced between January 1, 2002 and December 31, 2006. We hope that you find this white paper thought-provoking and that it contributes to a continuing dialogue on the economics of deal-making. This research has been conducted in consultation with Professor Steven Kaplan of the University of Chicago Booth School of Business.
Based on our analysis of normalized returns and the variables examined, we found:
- Cash-only deals had higher returns than stock-and-cash deals, and stock-only deals
- Acquirers with lower P/E ratios completed more successful deals
- The number of prior deals pursued by an acquirer was relevant; those who closed three to five deals were the most successful
- Transactions that were motivated by increasing “financial strength” were most successful
- Deals that were motivated by a desire to purchase IP or technology and those motivated by a desire to increase revenues were least successful
- The size of the acquirer (based on market capitalization) was not statistically significant
In this study, we analyzed the stock performance of companies that announced deals between 2002 and 2006, one and two years after the deal announcement. Stock prices were normalized on an industry basis. When we refer to a variable or acquisition characteristic as being successful, the characteristic is associated with stock returns that are both positive and statistically significant. The deals included in this study involved acquisitions where acquirers purchased 100 percent of the target, where the target constituted at least 20 percent of the sales of the acquirer and where the purchase price was in excess of US$100 million. The average deal size of the transactions in this study was US$3.4 billion; the median was US$0.7 billion.
The variables that we examined included the following:
- How the deal was financed—stock vs. cash, or both
- The size of the acquirer
- The price-to-earnings (“P/E”) ratio of the acquirer
- The P/E ratio of the target
- The prior deal experience of the acquirer
- The stated deal rationale
- Whether or not the deal was cross-border
Every deal possesses numerous characteristics: Is the deal being financed by cash, stock or a combination? Is the acquirer worth more than US$10 billion? Is its P/E ratio above or below average for that industry? Why is the acquirer doing the deal? While many of these factors are a given, such as a company’s market capitalization (“market cap”), it is still interesting to examine how these factors correlate with the success of recent deals.
Our study found that certain factors, including how the deal was financed, had a strong correlation with deal success. Other factors, such as the market cap of the acquirer, were not statistically significant. Deals that were financed with cash and those in which the acquirers had low P/E ratios were most strongly correlated with deal success. In terms of deal rationales, deals motivated by financial considerations were most successful. On the other hand, deals motivated by a desire to acquire intellectual property or to increase revenues were least successful. A detailed examination of these findings follows.
Does financing structure have an effect on a deal’s success? Cash deals, compared with stock deals, were significantly more successful, measured after both 12-month and 24-month intervals. Based on normalized stock returns, the average cash deal in the study showed a return of 1.0 percent after one year, and 2.9 percent after two years. In other words, acquirers financing deals with cash returned 1 percent above the industry average after one year. Deals financed solely with stock were significantly less successful. The average all-stock deal in our study returned negative 5.3 percent after 12 months and negative 9.8 percent after 24 months. Deals that were financed with both cash and stock performed between the two extremes and returned negative 3.8 percent after one year and negative 3.7 percent after two years.
These results are similar to those that we found in our previous study on deals announced between 2000 and 2004. During that time period, cash deals were also significantly more successful than stock deals.
Companies using stock may perceive their stock to be a “cheaper” currency than cash. They may also believe their stock prices have yet to reach their peak, allowing for stock price appreciation after the acquisition takes place.
In today’s marketplace, where credit is still hard to come by, it is likely that a larger percentage of deals will be financed with stock or cash on hand. Companies with relatively healthy balance sheets should, therefore, have an advantage as they pursue strategic acquisitions. Should more deals continue to be financed with cash, then we can expect to see smaller deal sizes—those valued at US$1 billion or less—dominating the marketplace.
Similar to our last study, acquisitions made by acquirers who had low P/E ratios compared to their industry peers were significantly more successful than acquisitions made by high P/E ratio acquirers. Acquirers whose P/E ratios were in the lowest quartile of this study saw an average return of 4.8 percent after one year and 8.5 per-cent two years after the deal was announced. Conversely, those companies whose P/E ratios placed them in the highest quartile experienced a zero percent return after one year and a negative 6.1 percent return after two years. These results are consistent with those of the 2007 study.
These findings may be due to several possible explanations. Acquirers with lower P/E ratios are probably not as tempted to engage in riskier deals since their stock is relatively under-priced in the market. In addition, if an acquirer’s P/E ratio is low, it would tend to value a target more conservatively than an acquirer with a higher P/E ratio in order to gain an arbitrage on the P/E multiple. An acquirer with a high P/E ratio may have a more difficult time increasing its value after a transaction, especially if over time its P/E reverts back to the industry mean.
The P/E ratio of the target was also statistically significant. In contrast to our previous study, acquirers who were able to purchase companies with P/E ratios below the industry median saw a negative 6.3 percent return after one year and a negative 6.0 percent return after two years. Acquirers who purchased targets with P/E ratios above the median, including those with negative P/E ratios, had a negative 1 percent return after one year and a negative 3.5 percent return after two years. These results are very different from the ones we found in our last study for deals announced between 2000 and 2004. Those earlier deals demonstrated the more anticipated results: acquirers who purchased targets with below average P/E ratios were more successful than acquirers who purchased targets with higher P/E ratios.
It is probable that in the deals announced between 2002 and 2006, acquirers who purchased targets with high P/E ratios were buying businesses that were growing and where the acquirer was able to achieve greater synergies. Deals announced between 2000 and 2004 included deals from the “dot-com” era, where high P/E ratios were often associated with unprofitable ventures that were not able to meet future income expectations.
How many is too many? While doing several acquisitions a year may allow acquirers to develop best practices, too many deals may be counterproductive. The study found that acquirers who engaged in six to ten deals were much less successful than acquirers who made between three to five acquisitions. Acquirers who made between six and ten acquisitions had negative 14.4 percent returns after one year and negative 18.5 percent return after two years. Companies that made three to five acquisitions a year saw their stock price increase 0.5 percent above the industry average after one year and 0.1 percent after two years.
A limited number of deals allows a company to focus on integration and makes it easier to devote the necessary resources to its integration efforts. It is very challenging for a company to attempt to integrate numerous transactions at one time, and those challenges may ultimately have a negative effect on profitability or other valuation metrics. Therefore, it is important that active acquirers have robust post-transaction processes in place for integration and synergy capture. Those who made fewer acquisitions may also have been discriminating in choosing an appropriate target, which increased their chances for deal success.
In order to determine whether certain deal rationales corresponded to more successful deals, our study examined statements made in press releases, public filings, and other publications. After one year, acquirers who stated that their acquisitions were motivated by increasing financial strength saw their stock prices increase by 2.9 per-cent above their industry peers; acquirers who said that their deals were motivated by geographic expansion saw their stock price increase by an average of 3.8 percent. After two years, those motivated by financial strength saw their stock price increase an average of 4.4 percent; but companies motivated by geographic expansion gained only 0.5 percent stock price increase after two years. These results are similar to those found in our 2007 study where deals motivated by financial strength were the most successful. In addition, acquirers who said they were motivated by the desire to purchase hard assets saw their stock price increase 4.6 percent after two years, a 121-basis point swing from a negative 7.5 percent return after one year.
Some deal rationales seemed to lead to less successful stock returns. After one year, companies whose stated motivation was acquiring intellectual property saw their stock prices decline by 10.8 percent in comparison to their industry peers. After two years, their stock prices declined by almost 11 percent. Acquirers who said their deals were motivated by increasing revenue saw their stock prices decline by 8.6 percent after one year and 12.7 percent after two years. In the 2007 study, acquirers who were motivated by the acquisition of IP and technology were also among the least successful acquirers.
These findings may be explained by the fact that companies motivated by financial strength have generally identified specific areas of synergies that may be implemented with focus, especially when compared with the more complex goal of increasing revenues. In addition, since this study includes deals affected by the stock market decline in 2008, companies whose deals increased financial strength were probably at a substantial advantage, compared to their peers.
As we found in the 2007 study, companies that made acquisitions motivated by a desire to increase revenues had a much more difficult task. Those companies need to get new products to new customers through more distribution channels. Those goals are much more difficult to achieve. Unsuccessful deals motivated by a desire to purchase intellectual property or technology may be the result of very high multiples, since companies with unique intellectual property may be able to command a high price. That higher price may ultimately not be justified, especially in today’s marketplace with more volatile revenue streams and less predictable consumer spending habits.
Certain factors that we examined for this study did not turn out to be statistically significant for deal success.
According to the data analyzed in this study, an acquisition itself did not have a statistically significant effect on the returns of the companies analyzed. In other words, the fact that a company announced an acquisition did not affect its stock price after one or two years. This data contrasts with the results of the study conducted in 2007 when we found that deal making had a positive effect on stock performance after both one and two years.
The size of the acquirer was not statistically significant in the deals completed between 2002 and 2006. We found that there was not a significant correlation between the market capitalization of the acquirer and post-transaction stock performance. In our earlier study, we found that on average, the deals completed by smaller acquirers were more successful than the deals completed by larger companies.
Similar to our earlier study, there was no correlation between deal success and whether a deal was cross border or if both the acquirer and target were in the same country.
Several deal characteristics tend to be present in the most successful deals, most notably deal currency and an acquirer’s P/E ratios. Those deal characteristics were positive indicators both in this study and in our 2007 study. What these factors usually indicate is that the acquirer is using currency that is not overvalued and that the acquisition’s financial justification has a realistic chance of success. Similarly, deals motivated by financial strength, a goal that may be simpler to achieve, also accompanied the deals that resulted in the greatest returns for shareholders in both time periods. We hope that this statistical analysis continues to spark discussions among deal makers and adds to the dialogue that helps both acquirers and targets create the most successful transactions.
This text was reprinted, with permission, from "The Determinants of M&A Success – What Factors Contribute to Deal Success?".
For more information, please contact:
Transaction Services—Global and Americas
Daniel D. Tiemann
+1 (312) 665 3599
+ 31 (20) 656 8953
+ 61 (2) 9335 7112