In the Classroom I
Q&A: Beating the M&A Odds

Robert W. Holthausen, PhD, the Nomura Securities Company Professor and Professor of Accounting and Finance and Management, has been academic director of Mergers & Acquisitions for the past 5 years and has conducted extensive research into identifying the processes involved in successful corporate mergers. He spoke with Wharton@Work: E-Buzz about the current state of merger activity.

E-Buzz: If so many M&As fail, why do companies keep trying this?

Holthausen: Many fail, and some are wildly successful. I think it's the chase for the wildly successful merger that keeps people going and probably the feeling that they won't be part of the failure statistics. Companies with very good processes beat the odds, and most managers believe they will too.

E-Buzz: What are the essential steps in an M&A process?

Holthausen: Basically, it's having a clear vision of the strategic rationale of the merger and understanding the essential elements one wants to get from the acquisition. Then it's a matter of keeping those key elements in clear focus through all of the different pieces of the acquisition process: integration; communication with customers and employees; negotiations; valuation; due diligence; financial; legal, and tax issues.

E-Buzz: How has the current economic downturn affected corporate mergers and acquisitions?

Holthausen: M&A activity slowed dramatically in 2001 relative to 2000 and hasn't experienced any great gains in 2002. Deal flow involving U.S. companies in 2001 was down approximately 35% relative to 2000. Non-U.S. deal flow (all deals not involving U.S. companies) was down 47% in 2001 relative to 2000. There has been no dramatic upturn in 2002 to my knowledge.

E-Buzz: Is now a good time to be looking for bargain prices?

Holthausen: Prices have certainly fallen, but they have fallen in part because expectations about future prospects have fallen. Nevertheless, there are a lot of companies out there right now whose valuations are reasonable given realistic expectations about their markets, which was less true in the late 1990's and early 2000.

However, at this time, funding is somewhat difficult if you are not sitting on cash, because the debt markets have been pretty uncooperative recently in terms of financing acquisitions. In addition, to the extent that acquiring companies' stock prices have fallen relative to 1999 and early 2000, managers don't think about using their stock as currency to fund acquisitions. This is because they don't feel their stock is overvalued, which they may have believed in 1999 and early 2000. Managers tend to use stock for acquisitions when they think their stock is overpriced.

E-Buzz: How is the extensive negative publicity surrounding such merger-intensive companies (e.g., Tyco, Enron, WorldCom) affecting M&A activity?

Holthausen: Most of these scandals did not have to do with misdeeds involving acquisitions. Tyco had some merger-related issues, but most of Tyco's issues were unrelated to mergers.

Perhaps of more interest to someone pursuing mergers and acquisitions is that the recent scandals and apparent failures by the accounting profession warn us once again that financial statements are not necessarily 100% true and accurate. Thus, in the process of doing an acquisition, one has to be very careful about whether the story portrayed by the financial statements is accurate or not.

If the financial statements have been fraudulently prepared and earnings are overstated and liabilities understated, then an acquirer would likely overpay. This suggests that the due diligence process is extremely important — as it always was. It also suggests that an acquirer should think about the corporate governance in place at a target, perhaps do background checks on key people, get a sense for the culture of the place, think about how executives are compensated, and what those incentives might imply about behavior, what types of internal controls are in place, etc.

E-Buzz: Are there limits to corporate expansion?

Holthausen: No one knows the answer to that in my opinion. In talking with someone very high up in IBM, he has often told me that one of the very interesting things about IBM relative to his prior experiences, at a startup and a medium-sized company, is how good IBM is at expanding and how it uses technology to control itself as it expands. With respect to growth by acquisition, an acquisition is very complex and, in order to do it well, not only does the acquisition process have to be managed well, but the appropriate key people have to be involved. As such, there are limits to how many acquisitions an organization can do at one time. However, if you have a very experienced group that handles the acquisitions and if you have a very good process, that increases the number a company could handle at any one time and over the long run.

E-Buzz: What's your prediction for the next 1 to 5 years in this area?

Holthausen: That's like asking what the economy will do. I think we will see an increase in M&A activity. Acquisitions have been cyclical (historically). As the economy recovers and as some uncertainty about economic prospects fades, we will see M&A activity increase. There are still lots of good reasons to engage in M&A activity, both inside and outside the United States. Europe is fertile for M&A activity. Because of the Euro, the individual economies in Europe are becoming more aligned and there has also been some favorable legislation as well as some regulatory rulings in Europe that will favor US acquisition of European companies, as well as cross-border transactions among European companies from different countries.

    

This month's articles:

  • Thought Leaders: Insights from a survey of more than 350 companies on successful CRM practices.

  • In the Classroom I: Professor Robert Holthausen on mergers and acquisitions in a time of economic turmoil and corporate scandals.

  • In the Classroom II: Use "discovery-driven planning" to test your assumptions in building businesses.

  • Certificate of Professional Development: A focus on value creation changed the way Schick executive Andrew Chrostowski approached his work.

  • The Last Word: The right knowledge can add value all along your value chain.