If you are a public company, the odds say that buying another corporation is a bad idea. Academic studies have consistently found that most deals fail, and the reason most commonly cited it that the buyers overpay. Yet as with second marriages, the continued popularity of corporate M&A is a triumph of hope over experience.
It’s predictable that corporate executives will talk themselves into dealmaking, especially since the acquiring CEO does better regardless of whether the deal works out. But why do shareholders continue to approve transactions that will damage their investment?
As reported by John Authers in the Financial Times, a study by Gregor Matvos (Harvard) and Michael Ostrovsky (Stanford) claims that the reason that shareholders go along with these deals is cross shareholdings. Not only are some of the shareholders of the buyer also owners of the seller, and that their net returns “do not significantly differ from zero.”
It’s a clever, and initially I thought brilliant observation, but upon reflection, I’m not convinced. Even though on average the institutional shareholders who own both companies own larger stakes of the target (15.5% of them versus 12.2%of the buyer), their economic interest in the seller is likely to be greater (the purchase would have to be worth at least 79% of the seller for the economic interest in the seller to be greater than that of the acquirer). And deals are costly to the acquirer in other ways: legal, investment banking, accounting, financing, and sometimes consulting fees.
Consider the more obvious reasons why deals are seldom opposed by shareholders. Retail shareholders are largely disenfranchised; many have unknowingly given their proxy to their broker, and even if they haven’t, many don’t go to the trouble to cast a symbolic vote. So the decision rests in the hands of institutional investors, many of which are money managers. All these money managers see large corporations as their most attractive business targets, for the company’s 401 (k) or defined benefits plan. Similarly, the asset management and brokerage operations of most investment banks usually are housed in the same division. The brokerage operations aren’t going to cast a vote against a current or potential client.
Now if shareholder votes were secret, and we still saw near-universal acquiescence to the wishes of management, then we’d need to look for other culprits. But the most obvious reasons are generally the most persuasive.
From the Financial Times:
Most big deals turn out to be big flops. Academic research over the years, and painful experience, point to the same conclusion, that big acquisitions of one public company by another seldom work out.
For every successful deal, there will usually be several bad ones. The bigger and more ambitious the deal, the more likely it is to end in embarrassment.
Of the biggest deals from the top of the last merger wave of the late 1990s, Chrysler is in the process of divorce from Daimler, TimeWarner has dropped AOL from its name and some critics even now say that Citigroup, product of the merger of Citicorp and Travelers, should split.
Shareholders have the last say on mergers and acquisitions. So why did they let through these deals, and many others far worse, with little or no opposition?
In deals structured as an acquisition, it is easy to see why the target’s shareholders acquiesce. They get a premium. But that makes it even harder to explain why shareholders of acquiring companies tolerate such behaviour. After all, their company is saying it will spend their money on paying more for an asset than the market thinks it is worth and the share price generally drops on the announcement.
Occasionally this may make sense, but it often has more to do with empire-building or the chief executive’s ego. You would expect opposition from shareholders.
New research by academics at the Harvard and Stanford business schools suggests an answer: the shareholders of the buyer and the target are one and the same. Cross-holdings are so widespread that the shareholders in the buying companies often regain their initial losses on the deal through the profits they make on the target.
Looking at mergers in the US from 1981 to 2003, the researchers found that shareholders in the acquiring firms lost money and did so significantly. But cross-owners, who held shares in both acquirer and target, generally profited.
Cross-owners made up 12.1 per cent of acquiring companies’ shares and 15.5 per cent of shares in the targets. The bigger the deal, the greater the cross- ownership: for the 100 biggest deals, cross-owners accounted for 42.2 per cent of the buyer and 45.7 per cent of the target.
According to Michael Ostrovsky of Stanford, one of the authors, this cross-ownership has grown over time – the average proportion of cross-owners in acquiring companies was only about 5 per cent at the beginning of the study.
Taking all owners of the acquirer into account, they found that their returns “do not significantly differ from zero” once cross-holdings are taken into account. So these deals are not bad enough to prompt institutions to oppose them.
As an example, they take the 2003 takeover by Bank of America of FleetBoston, the biggest bank in New England. Bank of America is a poster child for dilutive acquisitions and is now the biggest bank in the US. Hugh McColl, the CEO who spearheaded this expansion, would reassure markets that his bank’s buying spree was over, and then buy again. The huge office tower he built in Charlotte, North Carolina is nicknamed the “Taj McColl”. He had retired by 2003 but BofA remained the kind of acquirer of which shareholders should be wary. The week the FleetBoston deal was announced, BofA’s shares fell 7.5 per cent – $9.2bn of market value. But the market capitalisation of Fleet gained $9bn, reflecting the market’s belief that the new entity would be neither more nor less valuable than the sum of its parts.
Institutional investors in BofA also held 61.5 per cent of Fleet’s shares. As instit-utions were more heavily invested in Fleet than BofA (suggesting good stock-picking), the average instit-ution was up 0.3 per cent on the deal. So despite BofA’s 7.5 per cent decline, its institutional share-holders had no incentive to vote down the deal.
This incident is healthy, to some extent. Institutional funds should be diversified. If they have holdings in both companies they have balanced their risks nicely.
But there is a conflict of interest. It means normal market disciplines may not apply. The list of the biggest holders in both BofA and FleetBoston was dominated by fund managers best known for index funds. There are many reasons why passive investing is a good idea. But it leads to more cross-holdings and to investments that are more “passive.”
There is an emerging response to this. You can either buy cheap “beta” – passive exposure to the index – or more expensive “alpha” – an attempt to outperform with returns that are not correlated to the market.
Hunters for alpha, often in hedge funds, have many strategies. Merger arbitrage, or “special situations”, exploiting mispricings when deals are announced, is one of the more popular.
We may be moving to a world where most shares are held passively and the job of holding managements to account is left to a small but hyperactive group of “alpha-hunters”.
Cross-Ownership, Returns, and Voting in Mergers, by Gregor Matvos and Michael Ostrovsky, Social Science Research Network.
Keep in mind that most acquirers do NOT have to allow shareholders to vote on acquisitions, at least in the US, unless the target is very large. Also, many pension funds have been pushed by their labor union trustees to get companies to drop their poison pills thus encouraging acquisitions. This is a bit odd since unions were big backers of pills in the 80s when the first LBO boom took place. Unions are probably less interested in defending management these days given globalization’s impact on workers.
Thanks for your comment, and good catch. Authers said in his piece he was discussing large deals, but I neglected to repeat that in my write-up.
Governance is THE achilles heel of Anglo-Saxon capitalism, and I don’t know what you can do about it. Ownership is far too dispersed to allow effective oversight. Saying that the market will police bad management is just a fancy way of admitting that shareholders will get screwed.