When a CEO combines his ego and willingness to put precious capital on the line to grow his company bigger, faster, it can create disaster for investors.
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 about the tale of the toad and princess, let me get straight to the point now.
If there’s one quick way a lot of companies and their CEOs have destroyed a lot of shareholders’ wealth in the past, it is through mergers and acquisitions (M&A).
So in the world of M&A, 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.
Now, despite 50 years of evidence demonstrating that most acquisitions don’t create value for the acquiring company’s shareholders, corporate managers continue to make more deals, and bigger deals, every year.
Recent research shows that acquisitions in the 2000s have just as poor a record as they did in the 1970s or 1990s. There are plenty of reasons for this poor performance –
• Irrational exuberance about the strategic importance of the deal (which results in overvaluation of the acquired company);
• Enthusiasm built up during the excitement of negotiations; and
• Weak integration skills, largely due to clash of two different cultures
Many failures occur, though, simply because the acquiring company paid too much for the acquisition. It wasn’t a good deal on the day it was made – and it never will be.
What could be a bigger case of corporate misgovernance than a CEO wasting away precious capital that belongs to the company’s shareholders, just because he wants to satisfy his ego? Is that way to look at stewardship of capital?
By definition, “corporate governance” refers to how the top managers manage and mediate value creation for, and value transfer among, various stakeholders (including the society at large), in a context that simultaneously ensures accountability toward these stakeholders.
So, if there is a transfer of negative value to other stakeholders – except the managers who enjoy their hefty bonuses – that’s surely a case of corporate misgovernance.
Anyways, of such managers who make rash M&A decisions, here is something Warren Buffett wrote in his 1981 letter to shareholders…
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).
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 than they can digest, read what Buffett has to say about the success of acquisitions…especially the over-priced ones.
Ultimately, the key to success for a company in buying another company is knowing the maximum price it can pay and then having the discipline not to pay more.
Value creation is the basic purpose of all corporate activity. But in their bid to grow bigger, faster through acquisitions, this basic purpose is forgotten by most CEOs and their cohorts. The ultimate losers are shareholders.
Risking Cash, 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.
I’m sure Mr. Tanti and his likes have never read the sensible criteria that Buffett has laid down several times in the past for how Berkshire makes its acquisitions, which include –
1. Demonstrated consistent earning power;
2. Businesses earning good returns on equity while employing little or no debt;
3. Management in place;
4. Simple businesses; and
5. A (reasonable) offering price
How many CEOs practice this simple yet effective acquisition criterion? Not many! And thus you have so many spoiled princesses who are never able to turn toads into princes.
They’ll Shop Till They Drop
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 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. They conjure up fanciful “synergies” with the target company which, as the post mortems of failed acquisitions suggest, never come up.
What is more, if a CEO has made up his mind and is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors (aka investment bankers) will come up with whatever projections are needed to justify his stance.
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.
Now the question is – What tends to inflate the price that CEOs pay for acquisitions?
Seeking Wisdom–From Darwin to Munger, the author quotes Charlie Munger thus…
Marcus Porcius Cato said: “Men’s spirits are lifted when the times are prosperous, rich and happy, so that their pride and arrogance grow.” We tend to over-estimate our abilities and future prospects when we are knowledgeable on a subject, feel in control, or after we’ve been successful. As financial writer Roger Lowenstein writes in When Genius Failed: The Rise and Fall of Long-Term Capital Management: “There is nothing like success to blind one of the possibility of failure.
What tends to inflate the price that CEO’s pay for acquisitions? Studies found evidence of infection through three sources of hubris: 1) overconfidence after recent success, 2) a sense of self-importance; the belief that a high salary compared to other senior ranking executives imply skill, and 3) the CEO’s belief in their own press coverage. The media tend to glorify the CEO and over-attribute business success to the role of the CEO rather than to other factors and people. This makes CEO’s more likely to become both more overconfident about their abilities and more committed to the actions that made them media celebrities.
Peter Drucker said this to Time Magazine a few years back…
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
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. In fact, Ratan Tata’s successor Cyrus Mistry has already written off 14% of the US$ 16 billion invested by the former in M&As abroad.
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.
Watch Out for Spoiled Princesses
As an investor, it’s important for you to be very careful of managers and companies who often play spoilsport with capital allocation through rash acquisitions, and then justify such irrational decisions.
Also, a lot of companies making aggressive acquisitions are hotbeds of cash flow scams. How do they do that? Well, consider this.
Imagine you are a company that is getting ready to make a business acquisition. When you pay for the acquisition, you do so without affecting cash flow from operations (CFFO). If you buy the company with cash, the payment is recorded as an Investing outflow. If you offer stock instead, there is, of course, no cash outflow.
As soon as you gain control of the company, all of the ins and outs of the acquired business become a part of the combined company’s operations. For example, when the newly acquired company makes a sale, you naturally record that on your Income Statement as revenue.
Similarly, when the newly acquired company collects cash from a customer, you record that collection on your Statement of Cash Flows as an Operating inflow. Think about the cash flow implications of this situation. For one, you were able to generate a new cash flow stream (the acquired business) without any initial CFFO outflow. In contrast, companies that seek to grow their business organically would generally first incur CFFO outflows in order to build the new business.
Now, boosting your CFFO this way isn’t really illegal. But serial acquirers get this artificial boost repeatedly, and this becomes their reason for acquiring even more.
Make no mistake here. Companies that generate strong CFFO organically are great businesses. What you must be careful about are companies that make numerous acquisitions of mediocre companies and brag to investors about the strength of their underlying business, pointing to the exploding CFFO.
They know the real story: the CFFO boost had virtually nothing to do with the performance of their business. They took advantage of the loopholes in acquisition accounting rules.
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 fairytale. Yours could turn out to be a sorry tale.