The GE lightbulb then flickers [wk103]

In true British style, I have spent the last few of weeks building something up, only to knock it down. In response to recent posts, a friend observed, “General Electric shares also fell from $60 to $5 in 2009 because of GE Capital.”

GE had become an exemplary serial acquirer. Despite its well-known manufacturing legacy, GE had long been in the business of services. Through a series of acquisitions, its subsidiary GE Capital had become the largest US player in diversified financial services – larger that Fannie Mae and Freddie Mac, to give you a flavour of where this is going.

By the mid noughties, half of GE’s profits came from GE Capital. The relationship between GE’s traditional cashflows and the financial unit’s profits was a symbiotic one. GE’s reliable earnings afforded GE Capital a triple-A credit rating and a lower cost of debt than financial competitors without having to hold much capital on its balance sheet. GE Capital helped GE by financing the customers that buy GE turbines etc., and critically, enabling GE to “manage its earnings”. Due to the liquid nature of the financial assets, GE could quickly sell them at short notice to bring about GE’s legendary earnings results that regularly beat market estimates by a penny. Investors would happily pay more for predictable performance, and by the end of Jack Welch’s tenure in 2001, GE shares were trading at almost $60.

Between 2002 and 2006 interest rates were low, all assets seemed to be appreciating and GE Capital had decided to inject more debt into their acquisition programme. For example, the company had left the home mortgage business in 2000 but reentered it in 2004 when it bought the subprime lender WMC Mortgage. The financial crisis hit in 2007, and by April 2008, GE announced that first-quarter profits had fallen short of Wall Street’s expectations by $700 million, after reassuring the market investors a month before that it would hit its numbers. Bear Stearns had collapsed, causing credit markets to stall, which prevented GE Capital to deliver its usual “black box” magic to group earnings.

By mid-September and the failure of Lehman Brothers, things got much worse. GE had already tried to divest some of its businesses to raise funds, but no one would pay a respectable price under these conditions. Investors were gravitating towards risk free options. Eventually, GE had to strike a preferred stock deal with Warren Buffett’s Berkshire Hathaway in return for his investment seal of approval to coincide with a placing of $12 billion of common stock. This was not cheap capital and the markets knew it – GE was evidently desperate for cash to cover its debt obligations. By March 2009, the stock price dropped as low as $5.73.

GE survived on the back of its diversified portfolio (and more specifically its robust infrastructural division), as did Welch’s embattled successor Jeff Immelt, who set about scaling back GE Capital, to reduce its credit losses and to make it less volatile. He’s still there today.

Corporate development managers will know that acquisition growth programmes proceed through a number of fairly predictable stages: selecting possible acquisitions, narrowing the field, agreeing on a preferred target, assessing compliance with regulations, preliminary discussions, drafting a letter of intent, due diligence, negotiations, announcement, signatures, deal closure and integration. GE Capital were big contributors to the rule book on most of the processes and the market recognised that. $60 was evidently a premium stock market valuation.

I posit that the overvaluation, together with the drive of a new CEO, led to the overuse of the stock to buy assets of undervalued targets through merger. Combine this with the hubris and diminishing returns hypotheses mentioned previously in this blog, and what you have is an unhealthy feeding frenzy. Layer on top of that too much debt, an ambivalent (and almost dependent) market, unlucky timing and you suddenly have a recipe for failure. It has been said before, acquisitions are complex events that fail for numerous reasons.

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M&A the Jack Welch way [wk102]

In my week 100 post, I explored the notion that pre-merger integration processes are required because they foster better decisions about whether to proceed with an acquisition at all. But if my experience of investments in time and effort are anything to go by, it will take strong leadership to counteract the sunk cost bias, the vested interests of M&A teams rewarded for how many deals they make, salivating investment bankers, or the momentum from operations people who want growth so they can increase their responsibilities and boost their potential income. In Jack Welch, General Electric (GE) had a CEO who had no qualms about pulling the plug if the deal felt wrong, even if (what he calls) ‘deal heat’ was prevalent: “a frenzy of panic, overreaching, and paranoia, which intensifies with every additional would-be-acquirer on the scene …when they [people] want something that someone else wants, all reason can disappear”.

In his 2005 book ‘Winning’, the former CEO, sets out some of the telltale signs of a bad deal i.e. the prospect of value destruction.

1. Mergers of equals

The idea is noble, the reality a mess. Using the example of the DaimlerChrysler merger, Welch points out that “someone has to lead and someone has to follow, or both companies will end up standing still.” There is the risk that teams spend months duelling over who’s in charge.

2. Focusing on the strategic fit without assessing the cultural fit

The cultural fit of two companies is as important as strategic fit – if not more so. If two companies operate with distinctly different values, their cultures won’t combine, they’ll combust.

3. Reverse hostage situations

The third pitfall occurs when management wants to own a company so bad that they end up making too many concessions. By the time negotiations are over, the acquired company is virtually in charge.

4. Integrating too timidly

When it comes to integration, boldness is the most sensible approach. “If ninety days have passed after the deal is closed and people are still debating important matters of strategy and culture, you’ve been too timid. It’s time to act.” Don’t let uncertainty morph into inertia, or worse, fear.

5. Conqueror syndrome

The sin of ‘conqueror syndrome’ comes about when the acquirer immediately install its own people everywhere. One of the main reasons you do M&A is to get twice the talent to pick from. “This is a competitive advantage that you cannot let pass.”

6. Paying too much

This one’s pretty self explanatory, but we’re not talking about a 5% premium. He means the type of 20% or 30% premium that happens all too often.

Successful serial acquirers will excel at walking away from risky deals.

Pathfinder model for PMI* [wk101]

For those interested in best-practice guides, GE Capital acquisition-integration process has been discussed, debated, tested, changed, refined and, more importantly, codified. The ‘Pathfinder Model’ is a four-stage process – each stage representing a set of ‘predictable actions’, starting with the work that goes on before the acquisition is completed and ending with complete assimilation.

Preacquisition (due diligence, negotiation and announcement, close)

  • Begin cultural assessment
  • Identify business/cultural barriers to Integration Success
  • Select integration manager
  • Assess strengths and weaknesses of business and functional leaders
  • Develop communication strategy.

Foundation building (strategy formulation, acquisition integration workout, launch)

  • Formally introduce integration manager
  • Orient new executives to the firm and non-negotiables
  • Jointly formulate integration plan and 100 day plan
  • Visibly involve senior management
  • Provide sufficient resources and assign accountability.

Rapid integration (course assessment and adjustment, implementation)

  • Use process mapping to accelerate programming
  • Use audit staff to perform audits
  • Use feedback and learning to adapt integration plan continually
  • Initiate short-term management exchange.

Assimilation (long-term plan evaluation and adjustment, capitalising on success)

  • Continue developing common tools, practices, processes and language
  • Continue longer term management exchange
  • Perform integration audit.

There are some practical, sequenced steps above, but the model comes with a management warning. PMI is as much an art as it is a science. Its creators remind students of the art that they will need to improvise, but that the model can prevent improvisation becoming the whole show. What strikes me is the importance of keeping communication open and fast. On further reading, I have learnt that the original framework for their entire integration strategy was actually borne out of a communications plan. That original plan included is 48-hour comms blitz directed at employees immediately after the deal closed; the formulation of a role in the new organisation for the former target firm executives; a strategy for presenting the acquisition to the media; a way to handle some consolidations of HQ staff; and an outplacement plan. Integrating acquisitions evidently wasn’t the only core capability at GE Capital.

Pre-merger integration [wk100]

In 2000, I became a Partner and head of marketing at an aspirational property consultancy. Our core service proposition was technical due diligence services to real estate investors and lenders. Once legal due diligence had taken place, our surveyors would check the condition of the underlying asset… the roof, the curtain walling and any other key fabrics that made up the building envelope. It was not ‘sexy’ business, but it came with the excitement of a growth market. During the early noughties, we were able to build a pan-European network on the back of some key clients that were pushing the boundaries of cross-border property investment.

One of our key clients was GE Capital. GE Capital was founded in 1933 as a subsidiary of GE to provide consumer credit. However, by the end of the 1990s, it had become a financial services powerhouse with earnings of around $3billion, as I recall. The conglomerate’s range of business now spanned private credit card services, aircraft leasing and all things in between. GE Capital had grown through a number of successful acquisitions – between 1993-1998, it had made over 100 acquisitions and over 50% of its businesses had become part of GE Capital through acquisition. My business’s opportunity would come about when GE Capital was purchasing a portfolio of real estate assets to add volume to an existing business, or to open up business in a new European territory.

The acquisitions would come in a different shapes and sizes, but one thing was consistent – GE Capital was a valuable client. That is to say, they cared about due diligence and we were aware that we were plugged into some well-oiled machinery that represented industry best practice.

GE Capital had become an exemplar serial acquirer. By the late 1990s, GE Capital had been working for some time to make acquisition integration a core capability and a competitive advantage. It asked its executives to learn how to manage integration as a replicable process and not as a series of one-off events/ transactions. The scale of its acquisition programme allowed them, through trial-and-error, to form a refined pattern of best practice. In 1998, Robert H. Schaffer & Associates, a Stamford-based consultancy, revealed all in the Harvard Business Review in an article entitled ‘Making the Deal Real’. It had been working with GE Capital to develop and apply its acquisition integration process.

Lesson number one was that acquisition integration should not be treated a discrete phase of a deal; it is a process that begins with due diligence and runs through the ongoing management of the new enterprise.

‘Post-merger integration’ (PMI) is misnomer. It implies that integration begins after the deal is closed. GE Capital recognised that there were predictable issues that could be anticipated long before the deal actually closed. In the early 1990s, they formalized this thinking during due diligence (DD) for a Chicago-based equipment-leasing company. They began to convene a series of end-of-day meetings for the functional heads of the various DD teams to discuss daily lessons and what could be used to develop preliminary plans for managing the acquisition after the deal closed. Applying those lessons to subsequent acquisitions, they quickly found that being sensitive to integration issues during the due diligence phase began to foster better decisions about whether to proceed with an acquisition at all.

They had thereby made their case for pre-merger integration (PMI*).

M&A as a means to an end [wk99]

M&A research seems to be full of contradictions. Acquisitions can add real firepower to a growth agenda, but acquisition targets are better kept small. Acquirers have great potential to learn from their experience, but generally fail to realise that potential. Institutional investors will accept M&A if managers deliver long-term increases in total shareholder return, but a deal is deemed successful if it can deliver short-term cumulative abnormal returns.

While mulling over this last inconsistency, it seems to me that it is always going to be difficult to measure success, as the measurement is dependent on the rationale behind the transaction. As efficient as markets are, there will always be an information asymmetry between investors and managers. Then I thought that if the reason for purchasing is a variable, this in turn would once again make it more difficult to learn from acquisitions, because lessons from prior acquisitions will differ in their relevance.

Thankfully, before I descend into a spiral of further query, I am happy at this point to draw upon Mathew Hayward’s seminal study on acquisitions between 1990-1995. Published in 2002, Hayward confirms that frequent acquirers draw the wrong conclusions from acquisitions or misapply the lessons because acquisitions are diverse. That point is already clear. But his paper ‘When do firms learn from their acquisition experience?’ reveals some other interesting specifics about the things that confound acquirers’ ability to enjoy M&A learning.

  • Tempo is important.  Within his sample, he found that acquisitions were sporadic. And within the irregular frequency, he uncovered learning patterns. Very short intervals between acquisitions were often not long enough for inferences to be generated and applied in a timely fashion; and very long intervals between deals can cause them to become forgotten or irrelevant.
  • Making a (small) difference. If acquisitions are too similar or dissimilar to each other, this prevents acquirers from establishing what is different, special and important about the new opportunity. When prior acquisitions are highly similar to one another, acquirers will lack the generalist skills to appreciate a range of acquiring opportunities. When prior acquisitions are highly dissimilar to one another, acquirers will lack the specialist skills to extract gains from any one type of acquisition.
  • And finally, appreciate (small) mistakes. Managers tend not to search deeply for lessons from successful acquisitions as the success stifles the intensity of search for superior solutions. Large failures also stymie search because they raise questions about managers’ competence, causing all to become averse to further acquisition. Instead, small losses from prior acquisitions concentrates the search for richer inferences about what to subsequently acquire. Moreover, Hayward found that the greater firms’ experience with small losses, the greater the scope for this learning.

So to correct last week’s statement that serial acquirers should focus on small deals that are easily identifiable as previously experienced, they should, in fact, focus on small, regular, slightly different, slightly dilutive, learning M&A experiences. Is that what Intel and Cisco did? Lots of small acquisitions in products that allowed them to learn from markets? Perhaps it was the analysis of small failures that provided them with evidence of where the market potential resided and how the firm might compete for it.

In conclusion, this frames M&A as a means to end rather than an end in itself.

Limited acquisition experience counts [wk98]

In my last post, I became quickly intrigued by the assumption that learning is a good thing in M&A. It seems to me that in both the confidence drawn from previous successes and the propensity to become less risk averse because you become a better bidder, our prior experience can actually present a pitfall in itself.

In an environment in which you are trying to develop routines to standardise know-how, managers will face pressure to document and draw upon their previous acquisition experiences in an effort to achieve some measure of deal success. However, transfer of knowledge between acquisitions can result in both positive or negative effects. And the main reason for that is that acquisitions would seem to be very complex. The process consists of many interdependent activities, such as due diligence, negotiation, financing, and post-merger integration, each of which is complex in itself.

For champions of the ‘resource-based view’, this type of complexity can be a real competitive advantage. That is to say, if ambiguity exists over whether the source of the advantage is cause or effect, it is very difficult to imitate. However, that is because transfer of knowledge is clearly hindered. Now throw into the mix a broad experience of M&A e.g. a range of industries, geographies, target sizes, financial models, team CVs/resumes, and what you have is the risk of transferring old lessons to new settings where they do not apply. For example, because of the integration complexities associated with large deals, applying acquisition routines from previous, incomparable small deals can be detrimental to post-deal performance.

As industries continue to consolidate and global competition further intensifies, the trend toward making larger deals will persist. But it seems to me that if a large firm specialises in serial M&A as a clear growth strategy, it can reduce the risk of negative learning effects by creating M&A departments that focus on targets that are easily placed in a pigeonhole entitled ‘previously experienced’. So, that would suggest a need for a contradicting requirement for smaller targets that are much easier to turn into a routine of making smaller deals. Hardly the food of choice for the average CEO ego with just 3-5 years to make a mark.

The pitfalls of serial M&A [wk97]

Just as cogent as it is to assume that prior experience in M&A has a positive effect on future performance, it is easy to think that the counterbalance is some form of indulgent acquisition excess. While academics might disagree on the impact of factors, they would all agree that apart from the specter of value destruction, the pitfalls of serial acquisition do not have a single theme. Reading through their papers, acquisition overreach has many possible explanations.

  • The Indigestion Hypothesis proposes that the short time period between acquisitions adversely affects acquirers that quickly execute multiple acquisitions. Each subsequent acquisition results in worse performance than the previous acquisition, because the acquirer becomes less able to integrate successfully.
  • The Hubris Hypothesis is something I touched on in week 38 with the notion of a mythical ‘managerial kiss’. Managers in the acquiring firm assume that they can manage the target firms’ resources better than current management. Overconfidence drawn from previous success leads them to overpay for their targets, be less careful in their choice of targets, and/or take on too much debt to pay for targets.
  • The Mean Reversion Hypothesis argues that acquirers that initially do well at acquisition are unable in subsequent acquisitions to maintain the above average takeover performance. Since acquiring firms generally outperform the market prior to the merger, the underperformance subsequent to the merger may merely be a result of the mean-reversion in long horizon returns on individual stocks
  • The Diminishing Returns Hypothesis applies the diminishing efficiency of investment schedule to the firm’s acquisition programme. It argues that the best opportunities are taken first and so the decreasing attractiveness of the investment opportunity set means that value derived from subsequent deals are bound to decline over time.
  • The Bid Learning Hypothesis is another explanation for such a positive relation between the time between deals and acquisition performance. It argues that improved bidding capabilities by the executive leads to a higher number of successful bids, which in turn rationally increases their willingness to pay, which ultimately leads to a decreasing return pattern.
  • The Merger Programme Announcement Hypothesis proposes that that part of the overall performance effect of an M&A programme is already incorporated into a bidder’s share price. Should the market respond favourably to a first transaction announcement, when a second acquisition is announced, then there is some announcement gain since it is now a known event, but part of the value was already discounted in the share price.

So an interesting question would be under which conditions managers can navigate through these possible tendencies and learn how to acquire successfully again and again.

The secret to serial acquisition [wk96]

Over the course of the coming few weeks, I plan to interview a number of M&A executives as part of some research I am doing. My only criterion on finding suitable candidates is that they are in the strategic game of serial acquisition; that is to say, they have transacted multiple deals as a trade buyer as opposed to a financial buyer. In week 91, I raised the notion of a trend for SME companies selling out rather than going public on the basis that smaller independent companies are not a profit-maximising form of organisation in a globalised competitive environment. The flipside of that coin is the larger firms should be on the acquisition path. Winner takes all.

However, it is no secret that the evidence suggests that serial acquisition typically destroys value. I am curious in this interesting dilemma.

An abnormal return is the difference between the actual return of a security and the expected return. Abnormal returns will be triggered by events, such as acquisitions, which have not already been priced by the market. Therefore, short-term cumulative abnormal returns (CAR) is a measure of how capital markets see a deal upon announcement – as such, it is a relatively good proxy for long-term success, given that it will not be distorted by the noise (e.g. other capital investments, economic factors) experienced by longer-term measures, but does contain the risk of any forward-looking pricing.

Over the past 22 years, CAR averaged at -0.8% in public-to-public transactions. But, of course, averages hide granularity – there will be positive patterns and negative patterns, depending on the size of the deal, the bidder-to-target similarities, the market’s sentiment at the time, the M&A intelligence of the bidder… I could go on.

In recent months, there have been a lot of papers released by the MBB consultancies and alike on the secret to replicating M&A success.

  • Accenture’s ‘The Role of Finance in Successful Serial M&A’. The answers are the strong integration governance, a dedicated team, a steadfast focus on target realisation, a standardized PMI approach, and a robust enabling infrastructure.
  • Bain & Company’s ‘Four ways to improve your chances of success in M&A’. The answers are to align with the bigger picture, get the processes right, focus quickly on essentials, be persistent.
  • Booz & Co.’s ‘ The Capabilities Premium in M&A’. The answers are to acquire to enhance distinctive capabilities systems, leverage those capabilities systems, or do both.
  • McKinsey’s ‘Taking a longer-term look at M&A value creation’. The answer is to take a more programmatic approach to M&A, by employing a growth strategy built around a series of small deals. It is less risky than relying on organic growth or entertaining any large deals in fast-moving industries.

And my all encompassing favourite…

  • BCG’s ‘Does practice make perfect? How the top serial acquirers create value’. The answer is to target distressed businesses, keep transactions small, concentrate on private companies, think cross-border and consider whether now is the right timing.

Obviously, there is a large dose of vested interest in what you read in such papers. I assume that any research showing that M&A success is pure chance is not something that will be published by M&A consultants. However, the suggestion that you can learn from prior acquisitions and that this benefits acquirers does seem intuitive. So why is it that performance is so poor on average?

It must be possible to understand M&A performance better by taking a finer-grained qualitative look at the inside knowledge of key actors. Watch this space.

No Fear Finance [wk95]

I have seen the book ‘No Fear Finance’ floating around the halls of our school and, for the sake of full disclosure, the reason I decided to read it is that Fraser-Sampson was our Private Equity lecturer.

Consistent with his career in alternative investments, Guy Fraser-Sampson rails against the norm to give his readers an engaging approach to finance. I’ve just read ‘No Fear Finance’ chapter by chapter, which is not something you could say about your typical finance book. I wish it had been published prior to the start of my MBA – it would have given me the tools to hit the ground running.

This is not a text for the MSc specialist – but it is pitched at newcomers who want to cut through the financial jargon and be able to take a view based on a set of core principles. While the read is certainly no substitute for Fraser-Sampson’s years of experience, it does reveal his framing of finance. This layered structure is invaluable – readers can quickly link capital efficiency to WACC, to calculating IRR, to IRR’s role in capital allocation, to how a balance sheet fits into the grand scheme of risk and return, to a stock’s beta, etc.

Dispelling common misconceptions about the inaccessibility of finance, ‘No Fear Finance’ reveals everyday lessons. After reading the chapter on the time value of money, I worked out that my middle daughter discounts all promised treats by r=(FV/PV)-1 if there’s the option of one now. If you don’t understand what that means, this book is a good place to start.

China – surmountable challenges [wk94]

It’s been a while since we returned from Asia and I have used some of that time to reflect upon what I have learnt about China.

In Shanghai, we were treated to a talk from David Gosset, the Director of Academia Sinica Europea, an intellectual body that facilitates a mutual understanding between Europe and China. Evidently a ‘sinofile’, Gosset spoke passionately about China, the opportunities and the challenges. For all the evident opportunities in China, I wanted to draw attention to the challenges that chimed with my experiences in Shanghai and Beijing.

  • Rule of law. ‘Big corruption’ seems to exist in China. I saw more white Rolls Royces in Beijing than Shanghai (or anywhere else in the world). Beijing is to the headquarters for most of China’s largest state-owned companies. There is a need for a more independent media and judicial system.
  • The Environment. A quick boat journey down the Huangpu River in Shanghai and walk across Tiananmen Square reveals the pollution that is inevitable from such an explosion in growth. I am confident that China will use their financial and industrial muscle to develop a big, made-in-China, green energy technology some time soon.
  • Energy and food security. China has not secured the food and energy it requires to feed its engine. For example, China only has about 9% arable land.  And so, it cannot develop in isolation, which is great news. It will have to work together with other countries. It will be a co-architect. And from this stereotypical Westerner, let’s hope that brings the type of imports that seed both technology and a greater choice of cuisine.
  • And finally, anti-western sentiment. Much as the West misunderstands China, I am certain a reciprocal sentiment exists. The big problem with Western views of China is a mindset about Communist China. That was certainly the case with me, and rest assured, that myth exploded on arrival. But as much as China has changed, I got the feeling that we visitors were seen in a light that also draws on a bygone era. I did not see the ruins of the Old Summer Palace in Beijing, most of which did not survive the British and French fires of the Second Opium War (1860). By all accounts, the ruins serve as a reminder that China needs to be stronger in the face of ‘foreign imperialism’. I get the feeling that China understands this context more than the bedevilled detail. And for that reason alone, the West needs to be part of their renaissance rather than a bystander. As Monsieur Gosset would undoubtedly advocate, there is a need for a greater mutual understanding.

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