M&A risks
A valuator can help evaluate whether a deal makes sense

Mergers and acquisitions often make sense on paper. Purchasing a competitor may provide the buyer with an inorganic way to expand into new geographic markets or offer a broader product mix. Beyond increasing market share, the buyer may pursue a transaction to supplant operational weaknesses or to acquire talented workers in a scarce labor market. But many mergers and acquisitions fail to increase shareholder value.

Why buyers may overpay - Regardless of the industry or geographic location, several factors may cause a buyer to overpay and the merger or acquisition to fall short of expectations. For instance, there may be:

Inaccurate assumptions - A purchase price is only as reasonable as its underlying assumptions. In many cases, buyers forecast unrealistic synergies and economies of scale. Moreover, some buyers mistakenly believe they can run the business more efficiently than the previous owner.

Similarly, the buyer may analyze a transaction using unsupported hurdle rates (benchmarks used to evaluate investment decisions). Generally, the hurdle rate should be commensurate with the purchaser’s cost of capital. When a buyer uses a hurdle rate below its cost of capital, it is more likely to overpay.

Market-driven pricing pressures - Industry wide consolidation can sometimes lead to inflated pricing multiples. In some cases, valuation multiples may become detached from economic reality.

In the midst of frenetic merger and acquisition activity, management may feel compelled to pay overly high acquisition premiums to maintain sufficient market share. (See the article “Industry consolidation and value” in this issue.)

Incomplete valuation analyses - Before making a formal offer to merge with or acquire another business, management should obtain a thorough valuation analysis incorporating all three valuation approaches: cost, market and income approaches. Any differences between the outcomes of the three approaches should be reconciled to arrive at a reasonable purchase price.

Unfortunately, M&A participants often rely on industry “rules of thumb” and gut instinct, especially in mature industries. Although rules of thumb can provide a reasonable basis for initial M&A discussions, they fail to address important valuation considerations, such as non-operating assets and changes in market conditions. Therefore, they are rarely sufficient as the sole basis for a deal.

Consequences of overpayment - When companies overpay in a merger or an acquisition, the results can have a ripple effect throughout the organization. In some cases, ill-conceived deals can even lead to bankruptcy.

For instance, funeral home giant Loewen Group was unable to meet its debt obligations following an aggressive acquisition campaign in the 1990s. In 1999, when it was evident that its botched roll-up strategy missed the mark, Loewen sought bankruptcy protection.

Fortunately, this is a rather extreme example of the consequences of overpayment. Most companies don’t close their doors just because of one bad deal. More common consequences of overpayment include:

Reduced shareholder value - When a buyer overpays for a business, the cash and stock exchanged plus the additional debt load is greater than the present value of incremental future earnings. In mergers, overpayment dilutes the shareholders’ ownership percentage in the new entity. These value decrements are usually not reflected on the buyer’s balance sheet.

Deteriorated financial ratios - When a deal subsequently fails to meet expectations, it can adversely affect a buyer’s financial ratios, including profitability, liquidity and leverage metrics. Weaker ratios raise a red flag to commercial lenders and investors.

In some cases, financial ratios may fall below the benchmarks set forth in the companies’ loan covenants, leading to default. In others, lenders and investors will require a higher return, thereby increasing the company’s cost of capital.

Lost investment opportunities - Companies have resources to pursue only a limited number of investment opportunities. When they overpay in a merger or an acquisition, they can’t afford other essential activities and operations, such as research and development, new product launches, debt service and advertising campaigns.

Lessened stakeholder confidence - News of lackluster post-merger performance can adversely affect the buyer’s employees, lenders and investors. Accordingly, productivity may slide, key employees may abandon ship, bankers may call demand notes or investors may file class action lawsuits.

Lessons learned - The best defense against M&A failure is thorough due diligence. Valuation experts are well suited to help acquisitive companies and their attorneys evaluate M&A transactions. As objective outsiders, they can evaluate whether a deal makes sense from a financial perspective.

Sidebar: The importance of due diligence

Due diligence refers to the systematic process of evaluating a proposed deal. Comprehensive due diligence addresses financial, operational, technology and human resource issues. Beyond looking at financial statements and tax returns, buyers should perform site visits and interview personnel, customers and suppliers if possible.

When due diligence is performed too hastily or its scope is too narrow, buyers are likely to overlook deal-threatening risk factors, such as contingent liabilities, obsolete assets, concentration risks, poor internal controls, unpaid taxes or employee retention problems.

Problems and risk factors unearthed through acquisition due diligence should be investigated and reconciled. In some cases, the buyer may need to negotiate the deal’s terms. For example, to offset the risk of a significant contingent liability, the buyer may reduce the purchase price or negotiate a seller-funded escrow account.