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Wit, Wisdom, Warren (Issue #13): Spoiled Princess, Toads, and Acquisitions

“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” ~ Blaise Pascal

You must have heard the fairy tale where a spoiled princess reluctantly befriends a toad, who magically transforms into a handsome prince triggered by the princess kissing it.

Well, those were the older times.

Today’s capitalistic society has been witness to a large number of spoiled princesses trying the same trick on a large number of toads, only to realize that the tale of them turning into princes they had heard of was just that…a fairy tale.

If you are confused why I am writing today about the tale of the toad and princess, let me get straight to the point now.

As the title of today’s post says, I will cover Warren Buffett’s thoughts on corporate acquisitions. In this case, the spoiled princess is the company that is looking to acquire another company, and the toad is that other company that’s waiting to be acquired.

Of such acquirers, here is what Warren Buffett wrote in 1981…

Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget).

He added…

Such optimism is essential. Absent that rosy view, why else should the shareholders of Company A(cquisitor) want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own? In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite.

We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee‐deep in unresponsive toads.

How I wish the CEOs of Indian companies making or looking to make acquisitions bigger or worse than they can digest, read what Buffett has to say about the success of acquisitions…especially the over-priced ones.

Risking Cash and Reputation on a Coin Toss
Would you risk your life savings on a coin toss? Of course you wouldn’t. But over the past few years, CEOs of many Indian companies – large, mid, or small – have risked their business with the same odds – by making disastrous acquisitions.

So whether it was…

  • Tata Steel’s acquisition of Corus
  • Hindalco’s acquisition of Novelis
  • Dr Reddy’s acquisition of Betapharm
  • Biocon’s acquisition of Axicorp
  • Suzlon’s acquisition of Hansen and Repower
  • 3i Infotech’s many acquisitions
  • Indian Hotels’s acquisition of Orient Hotels
  • Opto Circuits’s acquisition of Cardiac Science

…CEOs after CEOs in India have shown what thrill for action when combined with cheap money can destroy shareholder wealth in such huge scales.

Apart from the hope that toads will turn into princes, Buffett gives two reasons so many companies get overenthusiastic about acquisitions.

The first reason was, as I mentioned above, the excitement of being in action. He wrote this in 1981…

Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and challenge.

Then, in 1982, he wrote…

…in many of these acquisitions, managerial intellect wilted in competition with managerial adrenaline. The thrill of the chase blinded the pursuers to the consequences of the catch.

Pascal’s observation seems apt: “It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room.”

The second reason Buffett gave was a CEO’s urgency to bring up his company to a large size before retiring, so as to justify a huge exist bonus.

He wrote this in 1981…

Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick.

(Ask a Fortune 500 manager where his corporation stands on that famous list and, invariably, the number responded will be from the list ranked by size of sales; he may well not even know where his corporation places on the list Fortune just as faithfully compiles ranking the same 500 corporations by profitability.)

Then, here is what he wrote in 1994…

The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer’s management; and they are a honey pot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives.

For all silly words you hear when a company is about to make an acquisition – like strategic fit, synergies, cost advantages etc. – know that in a large number of cases, the real keyword is “size” or “scale”.

Like, here is what Mr. Tulsi Tanti of Suzlon said while acquiring Hansen Transmission in March 2006…

The acquisition of Hansen gives us technological leadership and will make Suzlon a leading integrated wind turbine manufacturer in the world.

…over a period of time we will work with them in developing supply chain synergies.

And this is what the Investment Banking head of Yes Bank – who must have earned a fat fee – then said…

With this acquisition, Suzlon has truly emerged as a global player with significant market presence, manufacturing base and R&D centres…

…we see Suzlon becoming further cost competitive and providing an efficient and robust wind energy solution to its customers.

Here is Mr. Tanti again while selling Hansen in October 2011…

Today marks an important step towards deleveraging our balance sheet.

Now, let’s move from Suzlon to a much more “respected” company, i.e., Tata Steel, which acquired Corus in October 2006. This is what the company’s spokesman, surely fed by the management, had to say on the acquisition…

It is a big moment for Tata, this is a proud moment for the whole nation. This is the biggest foreign takeover ever by any Indian company.

On the other side of the table and happy at the expensive price he got from Tata Steel, the Chairman of Corus said…

This offer from Tata Steel reflects the substantial value created for Corus shareholders…

Then, the Investment Banker from ABN Amro, who was also the lender to Tata Steel for the acquisition expressed how good he felt that 2007 was going to be another bumper year for the steel industry and thus the acquisition was quite strategic for Tata Steel.

You see, like a “large-empire-but-poor-citizens” has been the aim of so many monarchs in history who gobbled up kingdoms after kingdoms, the secret wish of most acquirers and their investment bankers in the capitalist world isn’t any different.

Most research indicates that mergers and acquisitions (M&A) activity has an overall success rate of about 50% – basically a coin toss. But CEOs and their bankers avoid keeping those odds in mind, and for obvious reasons.

Buffett wrote this in 1997…

In some mergers there truly are major synergies – though oftentimes the acquirer pays too much to obtain them — but at other times the cost and revenue benefits that are projected prove illusory.

Of one thing, however, be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance.


Of Limping Horses and Foolish Valuations
Here is a story CEOs eyeing acquisitions – while assuming the target company to hold tremendous value for them, thanks to their own rosy projections and those prepared by the sellers and investment bankers – must read.

This is what Buffett had written in his 1995 letter…

…why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse.

Visiting the vet, he said: “Can you help me? Sometimes my horse walks just fine and sometimes he limps.”

The vet’s reply was pointed: “No problem – when he’s walking fine, sell him.”

This is in fact what a selling company often does – whether it is selling shares in an IPO or selling to a company – it sell out when there’s madness all around that would justify a super-normal price for its troubled business.

Buffett wrote in 1995…

At Berkshire, we have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale – a time when the business is likely to be walking “just fine.”

Even so, we do have a few advantages, perhaps the greatest being that we don’t have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners.

In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market.

Our practice of making this comparison – acquisitions against passive investments – is a discipline that managers focused simply on expansion seldom use.

He then cites Peter Druker…

Talking to Time Magazine a few years back, Peter Drucker got to the heart of things: “I will tell you a secret: Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work…dealmaking is romantic, sexy. That’s why you have deals that make no sense.”

Anyways, by making rosy predictions about the target company, managers also try to rationalize any price for the acquisition.

That’s like getting into the “commitment and consistency” bias.

First you commit to something, then you remain consistent with the original decision by justifying it using any argument and any amount of money.

In Corporate Finance, it’s called the “sunk cost fallacy”.

In the wise businessman’s lingo, it’s called ‘throwing good money after bad’.

In corporate mergers and acquisitions, the same bias forces managements to keep on allocating more capital into a recent merger in an attempt to revive it.

For example, take a look at Tata Steel’s expensive acquisition of the European steelmaker Corus.


In October 2006, Tata Steel proposed to buy Corus by paying 455 pence per share to the latter’s shareholders. While Corus’s management approved the acquisition, in November 2006, the Brazilian steel company CSN launched a counter offer for Corus at 475 pence per share. Tata then offered 500 pence, then CSN raised it to 515 and then to 603 pence per share.

In January 2007, Tata Steel finally announced that it was buying Corus at 608 pence per share, or 33% higher than its original bid of 455 pence!

As it stands now, after writing billions from its balance sheet towards losses at Corus, Tata Steel is looking to sell off some of the former’s assets in order to deleverage its balance sheet, apart from cutting jobs and closing manufacturing sites.

The company is in a fire-fighting mode and is trying to do everything under the sun to remain consistent with its original decision of buying Corus.

Not just Tata Steel and Corus, most acquisitions fail over the long run due to the commitment and consistency bias of the buyers. First, buyers pay expensive price for acquisitions and then when the expected benefits are not seen, they throw more good money after bad to remain consistent to their original actions instead of looking like fools.

As Buffett wrote in 1982…

While deals often fail in practice, they never fail in projections – if the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.

As an investor – existing or potential – in a company making an acquisition, it is important for you to beware of the projections from managers, sellers, and brokers…basically the entire acquisition process.

Here is what Buffett wrote in his 1995 letter…

…most deals do damage to the shareholders of the acquiring company. Too often, the words from HMS Pinafore apply: “Things are seldom what they seem, skim milk masquerades as cream.” Specifically, sellers and their representatives invariably present financial projections having more entertainment value than educational value.

And here’s some humour from Buffett on investment bankers, in his 1989 letter…

When they make these offerings, investment bankers display their humorous side: They dispense income and balance sheet projections extending five or more years into the future for companies they barely had heard of a few months earlier.

If you are shown such schedules, I suggest that you join in the fun: Ask the investment banker for the one-year budgets that his own firm prepared as the last few years began and then compare these with what actually happened.

Watch Out for the Spoiled Princess
Buffett wrote this in his 2000 letter…

We find it meaningful when an owner cares about whom he sells to. We like to do business with someone who loves his company, not just the money that a sale will bring him (though we certainly understand why he likes that as well). When this emotional attachment exists, it signals that important qualities will likely be found within the business: honest accounting, pride of product, respect for customers, and a loyal group of associates having a strong sense of direction.

The reverse is apt to be true, also. When an owner auctions off his business, exhibiting a total lack of interest in what follows, you will frequently find that it has been dressed up for sale, particularly when the seller is a “financial owner.”

And if owners behave with little regard for their business and its people, their conduct will often contaminate attitudes and practices throughout the company.

This is what he wrote of the sellers of businesses. We have already discussed enough about Buffett’s thoughts on the acquirers and how they rationalize stupid decisions and over-the-top valuations, duly helped by their investment bankers.

Buffett wrote in 1982…

If, however, the thirst for size and action is strong enough, the acquirer’s manager will find ample rationalizations for such a value‐destroying issuance of stock. Friendly investment bankers will reassure him as to the soundness of his actions. (Don’t ask the barber whether you need a haircut.)

As an investor, it’s important for you to be very careful of such managers – both buyers and sellers – and what you hear the investment bankers speak in media, again justifying such irrational decisions.

Of course, the upside of successful acquisitions can be substantial, but it’s also important for you to consider the base rate of success of acquisitions, which is very low…simply for the reason that most acquisitions lack business sense and are made at unjustified valuations.

Remember that acquisitions are often misused as the universal, over-simple growth formula, or just as a quick fix. As buying companies also boosts egos of managers making acquisitions, the essential questions can end up being dismissed as irrelevant, boring, or too mundane to be answered properly.

In all, be careful when you see the spoiled princess trying to kiss the ugly toad expecting it to turn into a beautiful prince.

That was a fairy tale. Yours could turn out to be a sorry tale.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Reni George says:

    Hi Vishal
    Good Afternoon to you

    So I was not wrong,the more you share your knowledge..the more is the knowledge gained by you,so you are gaining knowledge at a faster speed due to your speed of sharing.Kudos to you.

    So we all kiss the toads also in our investment cycle,remember the averaging of the bull shit stocks done by investors of suzlon,gmr,gvk,Lanco,R.com just to justify their buying decisions.And by that way we are making our good money run behind the bad stock and ultimately one day resigning ourselves to the fate and our luck and lastly we blame our luck and justify in that matter also that our luck did not support us in the matter of investment.

    One more thing we should know that,Acquisitions are also a tool in the hand of the corrupt management to siphon off the cash from the books and then later of writing of the amount as goodwill loss.I hope everyone might be remembering the purchase of India world by satyam for $115 million or nearly 500 crore during the year end of 1999 and that too in cash.well that one stroke of investment should have raised eyebrows of the shareholders and later we everyone know what happened with satyam.

    We should remember that Auction is on of the worst place to sit for a purchase.Tata steel a direct example of the same.Dan Ariely,Amos Travesky and Daniel Kahneman have made various studies about how the auction program impacts the rational thinking of our brain.The same auction theory rolls out during the IPO and the bull run,we do not want to miss out of the action.Remember an IPO is nothing but a different form of IPO,have you checked that whenever you apply for an IPO you always do it at the cut-off price,that means you do not want to be left out.An application at the cut-off price indicates that psychologically you have been overtaken by the Feeling of left out syndrome .Remember that auction cuts out your logical reasoning,and thats why we even try to outbid ourselves.The buying and selling of shares is one type of auction and we could see the play getting played daily in the market.

    Once again vishal a good and a class post,it is one of base of investing,which if got hold off could improve immensely the way you take decisions in the market.

    Thanks and Regards
    Happy and Safe Investing

    Reni George

  2. Anonymous says:

    Hi Vishal,

    Great article. Your observations are valid. I have my own share of thoughts on this why this fails:

    1) Most of the acquirers estimate synergies, very little attention is paid towards de-synergies. When corporate acquirers acquire target, they often miss out the broader picture – business cycles, financial risk, operational risks. E.g. when Airtel acquired certain African assets of Zain, they cited saturation in Indian telecom market and huge potential in African markets as synergy (measured in terms of metrics like Revenue per subscriber & so on). This was the sole driving factor behind acquisition of loss making assets in Zain Africa. I am not quite sure whether enough thought was given to the factors like political uncertainties, state of the telecom infrastructure in Africa. Any adverse findings in any of these areas means inability on the part of the company to replicate the Indian model in Africa. So if this model is not READILY replicable, that means that there are no real synergies.

    2) Buy-vs.build dilemma. This happens in an industry like software with high technological obsolescence. Acquisition of an IP is considered to be a critical mass in getting footprints in new market. However if that IP has no long term value, then does it make sense to pay 4x EBITDA to buy a company just for that? In other words does it make sense to ensure 5 year payback for acquiring an IP whose future is not sure even for four years?

    3) The most important fact you need to understand is the incentive bias. An organization is made up of semi-dependent power centers each having their own agendas and incentives. Lets consider a comparatively simple acquisition of an online retailer made by another online retailer say Flipkart. As you rightly pointed out, performance of most of the executives is judged by the topline. While decision making is collaborative, every department does not enjoy same weight. In most of the organizations sales is a power center and their performance is judged by the revenue they bring in. Hence their inclination is towards getting the deal done, no matter the price. CEO, COOs are typically judged by topline and hence their inclination to get deal done is higher. Now once a decision is made, human mind is incredibly good at justifying it.

  3. Sanjeev Bhatia says:

    Bang On, Vishal.

    The writings here are getting more and more delicious day by day. (I won’t use Reni’s wine analogy here ;).

    BTW, congrats on getting the SN blog listed on OSV recommended sites.

    Keep up the good work. (y)

    Happy Investing.

  4. Hi Vishal / Other tribesman ,

    Thanks for sharing your knowledge. i keep on waiting for updates and comments on your blog. it is such a pleasure to read them.

    i just wanted to add that though most of the time acquisitions are failures from investor perspective, we must make a rational opinion on acquisition.

    Here is what Buffett writes about characteristics of successful merger…

    In fairness, we should acknowledge that some acquisition
    records have been dazzling. Two major categories stand out.

    The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.

    The second category involves the managerial superstars – men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise. We salute such managers as Ben Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at National Service Industries, and especially Tom Murphy at Capital Cities Communications (a real managerial “twofer”, whose acquisition efforts have been properly focused in Category 1 and whose operating talents also make him a leader of Category 2).

    Buffet has been a fan of Henry Singleton. In Indian scenario we have Ajay Piramal with good acquisition record.

    Regards,
    Nitesh

    • Sanjeev Bhatia says:

      Agreed Nitesh. But just look at the BASE RATE. 🙂

      The probability of successful assimilation vis a vis potential disaster is what, I think, this article warns about. And here, the success rate is pretty low. Further, the more dangerous part is that whether the acquisition is successful or not will take quite some time to unfold, and by that time the damage would have been done.

      Happy Investing.

  5. Very well written, Vishal!

    Would you be interested in republishing some of them on Gurufocus?

    You can reach me by email.

    Thanks!

    Charlie.

  6. Completely agree with you Sanjeev …….we should not forget base rate 😉

  7. Too good to know

    I wish to know why current owner of business wish to sell ? What’s his motive to get exit as they are the best people to manage manage current business. If current owner has no interest or got smell of falling business or got scare of big faint coming or something in mind is bothering him. I have fundamental doubt how we judge that seller has what interest to sell to his business as its quite true profitable business can make to hold it and by over exposing business by speculation and over optimistic end up with lots of debt which no one likes. I found specially in information it company intensely started by someone and its present fixed motive one day it will be acquired by this group to show smartness and prove mad race to the world. I had been part of merger of one of last my venture as a working partner and one of ambisious business group was trying hard to enter in our skill domain and got fail since past ten years and decided to buys us complete cash 100% and other side seller my bosses typically 5 gem of people as a partners end up internal conflict and few of them lost interest to work together so they wish to exit so they have yo find someone to buy them and also they might had pressure from their venture capitalist who had entered three years ago with some exit mindset so they had show off their performance and somehow all went well and transaction happen and finally in two years or so group who had acquired has write off this business and still wonder why the first place they acquired us. I can only guessed they got cheap fund and it was idle and its big quetion on them not using effectively so better to invest and show off they have done the best deal. Its seems being outsider to know what’s cooking inside its near to impossible and judging management quality in our eye its too limiting. Books we don’t trust and their motive its impossible to find. I had small business and often my compititots quote so aggressively and by having good relationship I asked their ceo why you quote so low as their is negative margin and he is at least honest to me being close friend so said that if we don’t do business in certain size his presence not justifying sohe has to grab business at whatever price so till business owner wakes up he will find his presence some other company as other company conclude that this guy is super man as he did best job for past compnay so new want to give shot 🙂

    So show must go on we have to find own space to be safe and smart till our IQ and rest god might have something better plan for us

    Keep reading and Learning and heartily thanks to Vishal as I personally being an engineer learning lot from you simple writting skill . I am your truly fan and wish you more energy to write and good luck ahead

  8. You highlight a number of mergers/acquisitions. I would like to point out some others:

    Tata Motors-JLR
    Tata Tea-Tetley
    Sun Pharma-Taro
    Vodafone-Hutch
    Idea-Spice
    Rallis-Metahelix
    United Phosphorus-Many companies

    What are your thoughts on all these, and what are the lessons which we could learn from these? Would these be different lessons than the ones you highlighted?

    • Akshay Jain says:

      Taking on Samir’s point, can we find some common threads in acquisitions that (at least retrospectively) have made sense for the parent? If yes, what would some of these be. In other words, assuming the company I own has announced an acquisition, what are some of the factors I can look at to determine whether the acquisition would add value or destroy value? or do I just assume and conclude that the base rate is low, so net net acquisitions will always be negative.

      • Gaurav Bhagwat says:

        Valid points Akshay… Should we be looking at the past acquisitions history by the parent? Whether they participate/ed in the auctions? Why are they buying the target? How is acquisition financed? (All cash or issue of shares,,Raising debt)? Whats the process, they are following… Hope applies in tender offers as well.
        Here I would quote a classic case study (Its pretty old… 2000..Was in school by then). The case involves Prof. Sanjay Bakshi when he along with Mr. Abhishek Dalmia made a tender offer to acquire a company. Its interesting because: 1) We get an idea of the intent of raider when he made offer 2) The rigorous process followed by them 3) Mindset of the target. Read here.

        Gesco later got acquired by the Mahindras and became Mahindra Lifespace. I have not tracked the business so I dont know whether they overpaid or not. But I liked the emotionally detached approach taken by Mr. Dalmia and Prof. Bakshi when they evaluated the offer and quit from the bid when the offer no more made economic sense. Mahindra on the contrary was rescuer, a “White Knight”. Can somebody analyse whether his later acquisition made economic sense or not?

  9. punit lohani says:

    Everyday when I see the share price of Just Dial, I wonder how it commands a PE of 70.
    Thanks for the wonderful article.

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