Taking the “overpay” out of M&A

There are many reasons why companies pay too much in M&A transactions—but few legitimate excuses. Here’s a look at what boards can do to minimize their risk
By John Caldwell

Not a quarter goes by that we don’t hear another corporation announcing an asset writedown related to a previous acquisition. For example, earlier this year Valeant Pharmaceuticals International Inc. (TSX:VRX) took a $1.1-billon writedown of goodwill arising from several acquisitions.

It is also remarkable how quickly investors ignore these charges even when it involves hundreds of millions of dollars. Paradoxically, investors often applaud asset writedowns, particularly when they involve lowering future expenses. Most often, acquisition-related writedowns occur when the value falls below the original purchase price, suggesting that the corporation originally overpaid for the acquired business.

I have often wondered why executives are given a get-out-of-jail-free card when they are responsible for large value loss in an M&A transaction. In my view, there are three primary reasons. First, the acquisition likely occurred several years before and external conditions may have changed from what was originally envisioned and therefore rationalized. Second, boards of directors approved the transaction, so tangentially they carry some of the blame and are more likely to support the CEO. Finally, it is generally perceived that acquisitions are inherently risky so failure never seems to come as a surprise.

But the consequences of this outcome for a corporation and its shareholders are real and can be profound. To minimize the risk of overpaying, boards should examine the following underlying reasons why overpayments occur and take steps to avoid such pitfalls:

Overheated market valuations. With current equity markets at an all-time high, business valuations have reached stratospheric multiples of earnings. If history repeats itself, acquisitions made today are prime candidates for future writedowns.

Flawed strategy. With continuing pressure on executives to produce top-line growth, many turn to M&A as a way to boost revenues. Under the strain of investor sentiment, focused strategy may give way to M&A expediency and deal rationalization. There are also instances when corporations believe they are forced to act quickly and defensively because of competitor actions. This can lead to poor target selection and condensed due diligence—both potentially fatal errors.

Deal dynamics. There is only one reason why companies seeking to sell themselves run auctions. It creates competitive tension amongst potential buyers that drives valuations upwards. Additionally, advisers with success-based fees can be overly influential in unduly promoting transaction benefits and minimizing risk. I recall a personal instance when we were a buyer in an auction process and the target valuation had reached an unjustifiable level. Our adviser recommended we bid even higher not because the math worked but because “we just need to own this business.” We passed.

Poor analytics and inadequate due diligence. If I had a dollar for every million in synergies presented to boards, I would be a wealthy man. I would like to have a blunt conversation with the folks that dreamed up valuation methodologies such as multiples of revenue and EBITDA and internal rates of return with terminal values assuming perpetual success. While there are many ways to value a business, in my view there is none better than determining how long will it take to get your money back and then assessing if it is worthwhile given the risk. When it comes to due diligence, meanwhile, typical flaws than can impact valuation are failure to assess and validate the target’s strategy and its execution, and accepting buyer-prepared growth projections.

WHAT CAN BOARDS do to lower the risk of overpaying? Start by using common sense and applying discipline in overseeing strategy and M&A activities. Rigorous board involvement in assessing opportunities against well-defined acquisition criteria, including valuation, provides a valuable means to avoid unintended consequences. Boards should also instill rigour and skepticism around forecasts, synergies, valuation methodologies and deal structuring, as well as designing executive compensation arrangements that reward success and penalize failure.

John Caldwell is a veteran CEO and board member experienced in distressed situations and is the author of CPA Canada’s A Framework for Board Oversight of Enterprise Risk. E-mail: johncaldwell@rogers.com.


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