June 2015 | Finance
History is littered with examples, from AOL and Time Warner to Daimler and Chrysler, Kmart and Sears to Bank of America and Countrywide. Although there is a wealth of empirical evidence that shows an 80 percent failure rate for mergers and acquisitions, organizations just can’t seem to stop themselves from trying.
Companies that don’t want to end up as cautionary tales need to take a hard look at why these deals failed, and gain a clear understanding of valuation. But even then, says Wharton finance professor Itay Goldstein, highly intelligent, experienced senior executives make some very bad decisions. He tells participants in Integrating Finance and Strategy for Value Creation it’s often a case of the classic prisoners’ dilemma: cooperation is clearly in the best interest of both parties, and yet otherwise rational executives fall prey to competition that results in serious — and preventable — negative consequences.
Goldstein says these decisions are sometimes the result of managerial biases and those at the top who seek to maximize value for their own agenda rather than for the shareholder. They can also be due to difficult-to-sustain equilibrium. “In some acquisition scenarios, you have two parties who are eyeing a third. They might agree that both would be better off if neither of them acquired the third. But the equilibrium doesn’t last. Both fear the other one will make a move, gaining a competitive advantage that will destroy them, and then they go ballistic.”
He cites the case of railroad companies CSX and Norfolk Southern. Both had an interest in their competitor Conrail. CSX made an initial, reasonable offer to acquire Conrail, and then Norfolk Southern stepped in. “Bidding wars happen fast,” says Goldstein. “You don’t have a lot of time to react. So we see two companies increasing their projection of synergies, desperate to come up with a good set of numbers to justify the escalating price.”
Goldstein takes participants through the Conrail case in Integrating Finance and Strategy for Value Creation. “We look at how much the initial offers were, and calculate Conrail’s value. Then we look at how much was paid.” [In the end, the companies agreed to buy Conrail jointly for $10.3 billion — the most expensive railroad merger in history at the time.] Although he is careful to point out that not all of the details are known, Goldstein notes it’s clear that both CSX and Norfolk Southern used standard calculations to make sense of their offers.
“Many financial decisions get based on Net Present Value [NPV] analyses alone,” he explains. “But those in the organization who are tuned in to strategy can point out — and rightly so — that NPVs can miss opportunities. They might say, ‘If we take on this project, we will have an opportunity to do a follow-up project at a later date, one that could help us become an industry leader.’”
To include those considerations in the decision, Goldstein explains that instead of using only the NPV, option pricing can better capture a bigger value picture. In his example, the firm could calculate the value of the follow-up project and use that new figure to aid in the decision. “By integrating option pricing into the NPV, you can get a much clearer picture of the kind of value your decisions can generate.” It’s a calculation that can help identify opportunities that could create value — and those that could destroy it.
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