Baruch Lev is an accounting and finance professor (emeritus) at New York University, formerly at the University of Chicago, UC Berkeley, and Tel Aviv University. He formerly worked as an investment banker and a partner at a consulting firm. Feng Gu is a professor and Chair of Accounting and Law at the University at Buffalo School of Management.
What’s the big idea?
Corporate executives keep falling for the same trap: they think mergers and acquisitions will strengthen their company, but overwhelmingly confront massive failure instead. These choices put companies at risk and affect customers. Businesses need to remove incentives for simply attempting acquisitions so that the cautious leaders with winning strategies get rewarded.
Below, co-authors Baruch and Feng share five key insights from their new book, The M&A Failure Trap: Why Most Mergers and Acquisitions Fail and How the Few Succeed. Listen to the audio version—read by Baruch—in the Next Big Idea App.
1. Acquisitions should be the last resort.
Corporate acquisitions are frequently the largest investments companies make; they range from a few million to over a hundred billion dollars (Dow Chemical acquired DuPont in 2015 for $130 billion, for example). There are nearly 2,000 acquisitions annually in the U.S. and around 6,000 worldwide, for a total of $3–4 trillion. Acquisitions affect practically everyone: corporate executives and employees, the acquired company’s employees, investors, fund managers, and, in many cases, the competitive environment (airline mergers, for example, usually raise fares)—namely, corporate acquisitions affect you!
Using 40,000 acquisitions, our research shows that 70 –75 percent of all acquisitions fail to achieve their objectives. In fact, acquisitions are the largest destroyer of corporate value, investors’ wealth, and people’s careers. How can this be, and how can this be avoided?
Corporate acquisitions, where an acquired company is integrated into the buyer company, closely resemble organ transplants in humans. The acquired entity must be carefully chosen (donor matches recipient in transplants); the buyer-target integration is difficult and time-consuming (transplant operations are generally long), and the merger often fails (the body rejects the transplanted organ, despite massive medical efforts). For that reason, doctors turn to organ transplantation as a last resort. Only when everything else fails will they try a transplant.
That should be the case for M&A, but that is not the case in the business world. When companies hit a snag—the competitive situation worsens (sales are down, earnings turn to losses), patents are soon to expire, or big contracts aren’t renewed—the first thing to come to managers’ mind is making a big, transformative acquisition. Egged on by a chorus of commission-hungry investment bankers, consultants, and nagging activist investors, executives go straight to acquisition. The catastrophic case of Teva Pharmaceutical is a classical “urge to merge” case. In their haste, buyer executives often choose an inappropriate target, overpay for it, and conduct a superficial due diligence. A 70–75 percent acquisition failure rate is the consequence.
There are very effective alternatives to acquisitions, such as internal development of the required capabilities (patents), partnerships, and joint ventures. All alternatives should be carefully considered or tried, and corporate acquisition should be a last resort.
2. Conglomerate acquisitions are a lousy investment.
Conglomerate acquisitions, where the target operates in an industry unrelated to the buyer—like Amazon acquiring Whole Foods and Twitch, or Intel (semiconductor) acquiring Mobileye (autonomous driving)—now constitute about 40 percent of all acquisitions. Conglomerates of yore, like LTV and Gulf+Western, each operating businesses in ten to 15 unrelated industries, were the toast of the town in the 1960s and 1970s. Some even predicted that six to seven conglomerates would one day control the entire U.S. economy. This, of course, didn’t happen. Rather, conglomerates fell by the wayside in the 1980s and 1990s, causing untold losses to investors and misery to employees. Even the largest and longest survivor of them all—General Electric—is now a dim shadow of itself.
Business lesson learned? We thought so—until we saw the statistics. The dinosaurs are back. In the past ten to fifteen years, conglomerate acquisitions (particularly by cash-rich high-tech firms) were up, reaching nearly 40 percent of all recent acquisitions.
“When the buyer and target operate in different businesses, the merger has no synergies.”
Conglomerate acquisitions don’t make any economic sense. If you, as an Amazon shareholder, would like to benefit from investment in green supermarkets and get the risk diversification that comes with investing in companies operating in unrelated businesses, just add shares of Whole Foods to your Amazon investment. Why should Amazon do it for you by acquiring Whole Foods, in the process paying a 35 to 40 percent premium to Whole Foods’ shareholders at your expense? Yet, many companies do this. Worse yet, when the buyer and target operate in different businesses, the merger has no synergies. How did Whole Foods improve Amazon’s cloud activities? By feeding Amazon’s employees fresh, pesticide-free apples?
Many of these conglomerate acquisitions struggle. Amazon has desperately tried for ten years to revive Twitch, and Intel intends to sell Mobileye. Why do presumably smart executives continue making conglomerate acquisitions? The answer may lie in the self-serving motives of some CEOs. But most CEOs are genuinely motivated to improve their companies’ operations and advance the interests of shareholders. To them, we say, shun conglomerate acquisitions.
3. Avoid the wisdom of the crowds.
The voluminous literature on M&A—consultants’ advice, how-to books, and academic research in economics, law, and finance—frequently identifies the best times to buy businesses: “Acquire when capital markets are hot” using your high-priced stocks and when investors are euphoric about the prospects of the economy. Or: “Acquire when all your industry peers are buying” (like AI startups, currently) so that you won’t be left as a target, or as the only one holding out. “Acquire in a recession,” since target prices are low, or buy in your first year as CEO when your record is still untainted, and people expect bold moves.
The literature offers a bewildering choice of opportunities that many CEOs pursue. Merger waves are indeed correlated with stock prices, indicating that many CEOs follow the dictum “acquire in hot markets.” Similarly, evidence shows that many CEOs acquire businesses in their first two years of tenure. Following the crowd characterizes M&A, but the crucial question is how successful the acquisitions were made in those “opportune” times.
Our sample of 40,000 acquisitions allows us to test this question rigorously. We can compare the success of acquisitions made at the peaks of stock markets to those made during normal market periods or the success of acquisitions made during the first year of a CEO tenure to acquisitions made in later years. Surprisingly, we found that following the wisdom of the crowds in acquisitions is a loser. Acquisitions made during the presumed “opportune” times were substantially inferior in growing companies or increasing market share to those made in normal times.
Acquisitions should be made when internal circumstances call for it rather than when others are doing so. Also, acquisitions made under duress (hot market periods are short, as are recessions in the U.S.) often lead to picking a misfit target, overpaying for it, and conducting superficial due diligence—all recipes for failure. In acquisitions, follow your own strategy.
4. Set the acquisition incentives right.
A recent research study on acquisition bonuses mentions Exxon, HealthSouth, Bankers’ Trust, and Travelers Group, among many others, as paying their CEOs $5 – 14 million bonuses for the successful completion of M&A deals. This seems like Wimbledon changing its player rewards policy by awarding big money prizes for just playing in the tournament rather than for winning. Sounds insane, but that’s exactly how acquisition bonuses are being paid in corporate America: The bonus is awarded for completing a deal rather than for conducting a successful acquisition. Given a failure rate of 70 to 75 percent, the difference between completing and succeeding in acquisitions is substantial; in fact, huge.
“Our analysis shows that multiple acquisitions enhance CEO tenure by four to five years.”
However, CEO bonuses are only the tip of the compensation iceberg. Since, as most research has shown, company size is the major determinant of executives’ compensation (large companies are more difficult to manage, require better talent, etc., goes the argument), an acquisition, particularly a large one, will increase managers’ annual compensation year-in-and-year-out in addition to the one-time bonus. Furthermore, and most surprisingly, our analysis shows that multiple acquisitions enhance CEO tenure by four to five years. Apparently, directors are impressed by gung-ho managers who try to improve company performance by conducting multiple acquisitions, allowing them sufficient time to see these acquisitions through.
The penalty for acquisition failure is often a slap on the wrist. Corporate incentives are wrongly skewed toward conducting multiple acquisitions rather than succeeding in this endeavor. To remedy this serious deficiency, the emphasis on executives’ acquisition incentives should be sharply moved from making the deal to succeeding in it. Acquisition bonuses and compensation increases should be delayed for three to four years until the deal’s consequences are clear. Furthermore, penalties for botched acquisitions should be enhanced. Short of this, there will be no meaningful change in the devastating 70 to 75 percent acquisition failure rate.
5. Avoid holding on to losers for too long.
Amazon has been trying for almost ten years to make its acquisition of Twitch financially viable. In our opinion, the chances of success in the next few years are very slim, but Amazon will keep trying.
People are loath to admit failure in securities investments and corporate acquisitions. Therefore, they try to hold on to losers too long in the dim hope that circumstances will improve. More often, the situation worsens. Finance research abundantly shows that people hold on to losing investments. Holding on to failed acquisitions for too long wastes employees’ and executives’ time and diminishes the sales value of the failed target, often to zero.
Executives hold on to failed acquisitions for too long for two reasons:
- Sunk cost fallacy. Decision makers are wrongly affected by past investment (acquiring a company), saying to themselves, “We invested so much in this project; let’s try a bit more to make it work.” But past investments are sunk costs, totally irrelevant to the forward-looking decision about the likelihood of reviving the target. Only future costs and benefits are relevant, but executives often intermingle past (sunk) costs with future ones.
- Loss reporting. When a failed acquisition is sold or terminated, there is usually a substantial loss relative to the purchase price. This loss must be publicly reported in the company’s income statement. Failure to do so will cause a sharp drop in the stock price and embarrassing questions to executives about the wisdom of the acquisition.
The way out of this mess is to determine at acquisition a maximum period for the target’s full integration. If the target isn’t integrated successfully at the end of this period, a new integration team (unassociated with the acquisition) should be assigned to decide whether to sell or terminate the target or continue the rescue effort. Being unassociated with the acquisition, this new team will be unencumbered by its predecessor’s sunk cost and loss reporting inhibitions.
To listen to the audio version read by co-author Baruch Lev, download the Next Big Idea App today:
