By John Colley
In this article the author sheds light on why the likelihood of success, in terms of shareholder value creation, is further diminished during an enormous spending spree. He concludes that the various corporate governance measures designed to ensure there is alignment between boards and shareholder interests, although better than nothing, are far from being fully effective.
Year 2018 may become a global record year for the sheer volume of mergers and acquisitions, possibly approaching the previous highest of $4.6 trillion in 2015. Driven by high corporate profits, large cash balances and the ease of lending, corporates have spent like never before. Real costs of borrowing are around zero after tax relief and inflation. In the U.S.A., the spending spree has in addition been driven by significant tax concessions and a relatively strong dollar. The business environment outlook is also benign with only Brexit a significant shadow together with other global moves towards protectionism. How will shareholders fare during this enormous spending spree? Certainly, if large corporates have access to significant funds there is a temptation to spend it rather than distribute to the shareholder. History suggests the likely outcome is destruction of shareholder value on an industrial scale.
Shareholder Value Destruction
We do know that business prices relative to earnings have been increasing steadily ever since 2008,1 largely consistent with the increasing availability of funds for acquisitions. In effect the availability of more money is chasing prices higher to the point of almost certain shareholder destruction. In recent months we have seen Comcast, a U.S. global telecommunications conglomerate, acquire Sky, a European cable operator with 23 million customers, for £30.6bn. This was over 100% more than the previous undisturbed share price. Comcast shareholders immediately sold shares wiping £10bn off the Comcast share price indicating the extent of overvaluation they felt the deal demonstrated. On a lesser scale, Coca Cola has just agreed with UK-based Whitbread on the acquisition of Costa Coffee, a chain of predominantly UK-based coffee shops, for £3.9bn. This is around £1bn more than the expected IPO would have raised. The bid was also significantly above other buyer interest possibly also by £1bn. Coca Cola thought it was buying a “scalable coffee platform” to develop a global position. Instead they are buying a business with 88% of its sales and 95% of its profits in the rapidly maturing UK market. It is their first move into hot beverages. Some may say 20 years too late in view of the speed of the coffee market development.
Research is relatively clear and unambiguous on the success or otherwise of large scale mergers and acquisitions activity. Study after study finds that 60% to 80% fail to meet expectations and around 60% destroy shareholder value.2 Around half of all acquisitions are sold off again within 5 years. We also know that the performance of so-called mega deals is worse. When prices are reaching current heights, the likelihood of success in terms of shareholder value creation are still further diminished. In effect, very few of the recent mega deals will create value and the vast bulk will be value destroying. So why do shareholders let boards commit to so many deals which are not in shareholders’ interests? What motivates boards to take such major risks?
Boards do it as they see more power, status, and ultimately pay arising from the increase in size of the business. They also have a different outlook on risk when managing shareholder money rather than their own. They are well aware they would not see these benefits from giving the money back to the shareholders. Ultimately they have a significant conflict of interest, which is not aligned with the best interests of the shareholder. As for shareholders, they appoint boards to increase the value of the business and their shares. The job of the shareholder is not to run the business. In effect, the shareholders recourse is once boards have failed when they can fire the CEO and Chairman. In 2017, GE CEO Jeff Immelt was fired after 17 years in charge during which he completed transactions to the value of $126bn (advisors benefitted to the tune of $6bn). In 2018 the succeeding CEO, John Flannery, wrote $44bn off those transactions representing the extent of shareholder value destroyed. He was also duly fired as shareholder confidence in GE Leadership was lost.
Studying the aftermath of major transactions during the immediate following years is instructive regarding the success or otherwise of the deal. If the deal does not meet expectations, corporates are not keen to admit to their failure. However, for major deals it is very difficult to suppress or disguise significant underperformance. Announcement of deals is normally surrounded by much hype and euphoria particularly from the many constituencies who will directly benefit. This includes target shareholders who usually see a highly priced exit, and the many advisors such as investment banks, accountants and lawyers. The bidder shareholders are normally presented with a rationale supporting the deal which projects increasing shareholder value. Most major deals require shareholder approval. However is the presented case optimistic and what is the likelihood of it being achieved? That will become apparent over the following years.
What we do know is that businesses significantly overpay to the extent of passing all their future synergies from merging with the target to the target shareholders. Typically we see share price premiums of 30% to 40% over the undisturbed share price prior to any bid. This premium reflects the current value of the business plus future benefits. However currently this premium looks to be increasing not just with the 100% plus paid by Comcast for Sky. The price paid by Coke Cola looks extreme and seems unlikely to be recouped.
AB InBev, the world’s biggest brewer bought the second biggest SABMiller in 2016 for $107bn, more than 50% above the undisturbed share price. Two years on the share price is down over 40% as the business struggles with $108bn of debt and the dividend has just been cut. Competition authorities forced the sale of all the acquire businesses in North America, Europe and China.
Trade buyers are often willing to pay whatever it takes to capture a target unlike the more disciplined financial buyers. Indeed in most bidding situations which involve both trade and financial buyers, the trade buyers usually heavily outbid the financial buyers. Trade buyers often feel that the target may not become available again, or could be acquired by a competitor, and so pay whatever is necessary aware that they ultimately may be destroying value.
Another key source of value destruction is the integration period. Integration is an inward looking process in which staff jockey for a reducing number of positions. Uncertainty reigns as it may take some time to determine who goes and who stays. During this period key staff may leave as they want to control their own destiny. Often, the younger more dynamic staff moves leaving those who may have more difficulty moving. Indeed competitors, aware of the uncertainty, will target staff with attractive offers to lure them away. The impact can be significant.
During this highly vulnerable integration period it is common to also lose market share. Customers may be uncertain about the new ownership. Sales people may be more concerned about their jobs than keeping customers happy. Again customers are normally targeted by competitors during this period and lured away. In recent major acquisitions the London based software house Micro Focus acquired a bundle of businesses from Hewlett Packard (HP) for $8.8bn in a cash and paper deal in 2017 (These businesses included Autonomy, a big data UK-based business previously bought by HP for £11.7bn. Ninety percent of the value had already been written off the business in a year). In 2018, around a year after the deal with Micro Focus was done, U.S. sales collapsed by 12% as many of the U.S. sales force left. With no new pipeline for U.S. sales Micro Focus’ share price crashed by 46%.
A similar situation occurred in the £11bn merger between two Scottish fund managers Standard Life and Aberdeen Asset Management in 2017. The objective of the merger was to lower costs by saving £200M to better compete with the lower cost passive tracker funds. However, there was a major haemorrhage of investment funds as clients took their money elsewhere. The share price of Standard Life Aberdeen has now collapsed 40% since the merger took place.
Many acquiring businesses have not fully thought through their integration plans resulting in protracted and defective integration. The people negotiating the deal are quite different to those charged with integration who are often only introduced late in the progress. Deal makers are dominated by finance and legal personnel whilst integration requires operational people who know how to run the business. The more protracted the integration period the greater the prospect of lost market share and key staff. This period should be kept to a minimum. Indeed it is an advantage of Private Equity that they very rarely integrate businesses.
In view of the apparent divergence between the actions of the board and the interests of the shareholders then, what measures are in place to attempt to create some form of alignment between these divergent interests? Clearly these vary in almost every country. As a general principle it is apparent that the more concentrated the shareholdings, the more influence shareholders wield. In the UK, listed shareholdings are quite concentrated in the hands of institutions, fund managers and pension schemes. As a consequence, boards can meet a significant percentage of their shareholders in a few meetings. It was London-based institutions which recently voted down Unilever’s plan to move its head office to Holland in an apparent protectionist measure, where courts are resistant to foreign takeovers. This would also entail leaving the FTSE100 Index which attracts many passive investors. This was following the Kraft Heinz $143bn bid for Unilever a year earlier.
Non-Executive Directors (NEDs)
In some corporate governance regimes, NEDs are appointed to ensure that the position of the shareholder is considered when making important decisions. NEDs are also there to ensure compliance with laws and listing requirements, offer advice and ensure that values and ethics are upheld. However there remains some scepticism as to their effectiveness. They are normally chosen by the Chairman although this is usually after consultation with the CEO. Neither is likely to select people who might “make waves”. Indeed, NEDs often have a number of similar positions which means they can spend only limited time on any business. Whilst their contracts may stipulate two days a month many will try and keep it to board meetings and little more. They are rarely from the industry in question and so may have little grasp of the competitive dynamics. Information fed to them is carefully filtered and managed to achieve the desired effect in terms of actions and approvals.
Remuneration is significant in relation to responsibilities which may encourage NEDs to ‘tow the line” and not make stands against potential high risk decisions. Famously the late Richard Cousins resigned as NED of Tesco in protest at the Booker Diversification deal at a time when Tesco was struggling in its home markets. However that is a somewhat rare event. NEDs rarely resign even when facing serious value destroying decisions. The chairman apart they rarely meet shareholders to understand and represent their views. There is some evidence to suggest NEDs may not always entirely understand the position of the business. Certainly recent casualties such as Carillion suggest that NEDs had limited insight into the finances over quite a protracted period prior to the business entering liquidation. Again the specialised nature of the contracting industry may have played a part.
Overall, the various corporate governance measures designed to ensure there is alignment between boards and shareholder interests are better than nothing. However, they are far from being fully effective. Meanwhile, surplus cash and the ability to readily borrow at almost nil cost are driving acquisition activity and prices steeply upward. The prospect of current mega deals creating shareholder value are thin indeed. Shareholders are unlikely to benefit from the current acquisition binge and boards may find there is a day of reckoning to come when the outcome of these deals is known over the next few years.
About the Author
John Colley is Professor of Practice in Strategy and Leadership, Pro Dean, at Warwick Business School. Following an early career in Finance, John was Group Managing Director of a FTSE 100 business and then Executive Managing Director of a French CAC40 business. Currently, John chairs two businesses and advises private businesses at board level. Until recently he chaired a listed PLC.
2.Martin RL. (2016). M&A The One Thing You Need to Get Right. HBR Org. https://hbr.org/2016/06/ma-the-one-thing-you-need-to-get-right