Governance Leadership Centre: Global M&A activity fell 17 per cent in the past year, through May 2016. Why has M&A activity fallen after strong previous gains?
David Harding: M&A is always cyclical and always will be. Last year was the biggest M&A year in history, driven largely by megadeals, cheap debt and a global regulatory regime that let some big-scale-driven combos fly.
We would do well to remember that true value creation from M&A generally does not come from the few “big bets” that dominate headlines every year, but from the scores of smaller deals structured by executives who have a track record of finding deals, performing diligence and integrating businesses.
The health of the market for these smaller deals is better when compared to 2015—because the economics for these types of deals often remains compelling.
Do you expect M&A activity to pick up pace in 2016–17?
History suggests that there is persistence to the pattern of M&A, so there is unlikely to be a huge swing back up. Uncertainty in interest rates and regulatory environments would support that contention.
Numerous antitrust (competition review) boards have turned down deals in the last several months. Uncertainly is also created by the likely policy changes coming out of the US presidential election—that, in turn, may influence trade agreements like the Trans-Pacific Partnership and global US tax policy.
While the world is still awash in capital and global interest rates are low by historic standards, the volatility of financial markets so far this year and a general trend toward tightening may scuttle some deals—particularly those relying on the high-yield market, which has been quite volatile.
What will be the main drivers of M&A activity over three to five years?
Every deal has its own investment thesis, and the underlying forces are many, but given that the world will still be operating in a capital-abundant atmosphere, with low interest rates, there are three major themes that strike us as salient:
- Capability-driven growth. Companies will fill gaps in their capabilities, whether they be technological, geographic or functional, by selectively acquiring smaller organisations that bring unique abilities and market reach. In our research, this may be the best path to creating value from M&A, especially if you can repeat the formula.
- The thirst for scale. In a slower-growth world, and particularly one where commodity prices are pressured, we can expect management teams to look to boost earnings through scale business combinations. This will release shorter-term synergies, and at least in theory, longer-term margin benefits. We should caution that these types of scale deals, particularly the larger ones, have a chequered track record of success.
- Cross-border investing. Despite headwinds that are buffeting the globalisation of commerce, we continue to expect to see large flows of capital to support moves into new markets. This will include outbound investing from Asia into the Americas and Europe, as well as developed market investing into attractive emerging economies such as Africa.
Do you expect more "left-field" acquisitions—that is, large companies acquiring smaller competitors in "radical" adjacencies to participate in digital disruption?
We hope not.
We know that deal success rates have generally gone up over time. We like to think that this is a result of, at least a little bit, paying attention to the lessons of the past. Those lessons suggest that success in M&A comes from developing a repeatable model for buying companies, and they suggest that the best deals reinforce your core and expand your capabilities.
“Left field” and “radical” fall outside of that prescription. If you are an investor or director, we would urge you to exercise caution if those phrases are in the investment thesis.
Do you see any particular geographies or industries where M&A could be most pronounced?
There are macroeconomic trends that on the margin are driving M&A activity—the slowdown in China and market volatility in commodities, for example. But the long-term trends driving business combinations are present globally.
Do you expect to see more "de-mergers" as large companies spin-off unrelated assets in the next three years, and if so, why?
Yes and no.
We need to define some terms here. A separation is an action to “de-merge” or break a company in two or more pieces. A spin-out or a divestiture we consider to be the “sale” of a noncore asset. The market forces driving separations seem at this stage to be stronger than the market forces driving divestitures.
While the absolute number of separations are small, they represent big events. The impetus for these moves exist when there is a conglomerate discount in which one or more businesses are not compatible—for example, because one part is high growth and the other is low growth. By separating, you can get a parenting advantage, as each part is owned by the right investor. These moves have a good track record of success.
Divestures, in theory are also good moves, allowing better focus on the core. The forces pushing against divestitures are powerful, however. First, most divestitures entail significant cost "dis-synergies," often coupled with a dilutive effect on cash flow and interest coverage.
Second, in a low-cost-capital environment, the penalty paid for holding a less attractive, noncore business is not as great. To add insult to injury, it is often hard to put proceeds to work at an attractive rate of return.
Finally, significant tax penalties accrue to divestitures in many jurisdictions. Considering all of this, it is not worth the organisational disruption that occurs. That said, prices in many places are high, so if you want to sell, this might be a time to do it.
All in all, these forces are likely to keep divestiture activity below what you think it should be.
When presented with an M&A deal by their executive team, what are some key things boards should consider before approving an acquisition?
- Do you understand the deal thesis? Why will this deal make your existing business more valuable? The deal thesis should be credible and not based on defence, or "strategic" option value.
- Are you seeing both sides of the issue, or are you being “sold”? Make sure that the issues surrounding the deal—and every deal has them—are being properly brought to the fore.
- Do you have confidence in the cultural fit of the two companies? Why do you think this will work?
- How thorough is the integration plan? Are there proper targets and milestones to bring the businesses together? How will you gauge accountability?
- Finally, how will this impact the balance sheet and the investor message? Is the communication plan to stakeholders well-articulated? What will the deal do to the existing investors in the business?
What about on the other side—selling an asset? What should boards think about before approving a divestiture, and what are the key traps with asset sales? Are boards generally more willing for assets to be sold than bought?
It is so much easier to buy than to sell.
As discussed, the forces against selling a business are quite intense—things are often pretty bad before a decision to sell is made. The justification is often more around fit and ability to manage than financial performance. In a low-growth environment, it is often hard to justify getting smaller.
It makes sense for the board to ask for an annual portfolio review, and ask if the full cost of keeping noncore assets in the business are really justified.
Where do companies, generally, go wrong with M&A?
The three big reasons for deal failure are well known:
- Poor strategic and/or cultural fit;
- Missing key items in diligence; and
- Failure of the integration process—either to capture synergies or the process breaks down.
We observe that valuation, per se, is almost never a cause of deal failure. If a deal is sound, it is rare that it would be branded a failure solely because a company paid too much, and if a deal is a strategic disaster there is no solace in the fact that it did not cost much.
What makes a great M&A?
The ability to institutionalise—the ability to find deals, perform diligence and integrate companies that add to your strategic capabilities over and over again. We call this the repeatable model of M&A—and done well this will drive long-term shareholder returns (TSR).
As an aside, long-term TSR is almost completely a function of the growth in operating earnings. The market does not seem to care if operating earnings growth comes from organic sources or inorganic sources. So if you can consistently add to your operating earnings with sound acquisitions, you will be a TSR winner.
Once the deal is done, what steps can boards take to ensure the implementation matches the rationale for acquiring an asset?
A truism is “measurement drives management.” As part of the integration planning and follow-up, clear goals with related accountabilities work well to drive focus and flawless execution. The milestones and benchmarks should roll up to board updates. There is also a best demonstrated practice of an “after action” report to look at past deals and evaluate how results differed from the original investment case. Sadly, few companies do this rigorously.
Do organisations think enough about the culture of the organisation being acquired and whether it fits the culture of the acquiring company?
More so now than in the past. Sensitivity to culture and the performance of human due diligence is much more common than it was 10 years ago. As noted, missing the mark on culture is one of the big three reasons why deals fail.
The best way to do this is to complete a cultural risk assessment early in the deal process, and then over-communicate to the organisation. The communications need to be about the issues that affect the associates involved, not about how wonderful this deal will be for other stakeholders.
In your opinion, are non-executive directors as deeply involved in M&A as they should be—that is, across the detail?
We are conscious of the fact that the role of the board is to provide oversight and guidance to management while looking out for the best interest of the shareholders. To that end, the recommendation is not one for more involvement but for better involvement.
Board members need to understand the investment thesis and logic for the deal. They must be comfortable that the diligence process will surface and properly deal with issues, and they need to be assured that integration and cultural issues are being well managed. This is best done through transparent communication that includes milestones and accountability. If the stoplight assessment of the situation is green, then let management do its job. If there are yellows and reds, the board should know why and how the issues will be remediated.
We encourage board members to ask the “big dumb questions.” Why are we doing this? Who is responsible? How will the existing stakeholders benefit? If those answers are not satisfactory, then more work needs to be done.