1 May 2015

Capitalism’s secret death wish


If all goes according to plan, the next few weeks or months should see many if not most of us made measurably poorer. It’s nothing to do with taxes, crashes, or meltdowns. It’s nothing to do with politics. It’s something that will happen as a result of a well-established routine run by investment banks, financial advisors, and a host of big companies with very familiar names. It’s a kind of capitalist death wish, something that hasn’t been seen for a while – but now it’s back.

It’s called M&A – mergers and acquisitions to ordinary English speakers. The near future will see the conclusion of several of the biggest corporate acquisitions for many a year. The Anglo-Dutch energy group Shell will buy British Gas or ‘BG’, in one of the ten most costly acquisitions of all time. Nokia will buy Alcatel-Lucent, making Nokia one of the biggest telecommunications companies in the world. These deals (along with smaller ones that most of us will never hear about) will make the fortunes of many: managerial suits in the companies themselves, dealmakers in the banks that advise them, lawyers who write the contracts.

And most of these deals will be commercial disasters. Anyone who depends to any extent, directly or indirectly, on the profits and share prices of the corporate economies of Europe (and if you have a pension, or insurance policy, or even just a job, that means you) will be poorer as a result of them. The merged companies will in most cases make smaller profits than if they had stayed separate. Many jobs will disappear. The costs of unifying physical offices and information systems and intangible ways of doing things will be enormous. In the phrase of investment professionals, ‘value’ will be destroyed, big time.

What is more, everyone involved has good reason to know that this will happen. The history of corporate dealmaking is littered with destructive acquisitions. While the academic literature on M&A disagrees on the exact rate of failure, it is unambiguous on one point: most acquisitions fail.

Take the Nokia deal. Nokia is now a communications networking company (the part of the company that makes the mobile phone handsets now belongs to Microsoft). Nokia has long experience of the difficulty of making a big merger work, having been in a troubled alliance with Siemens since 2006 (ending in a full acquisition of the Siemens networks business in 2013) a period which saw the loss of thousands of jobs and a fall in the share price of around 80%. The company that Nokia is buying, Alcatel-Lucent, has a strangely similar story to tell: it is itself the result of an ill-judged merger between French Alcatel and the US Lucent (a guaranteed value bonfire if ever there was one). Alcatel-Lucent’s share price has also fallen by around 80% since the merger.

These are by no means the most destructive mergers on record – the marriages of Vodafone and German telecoms group Mannesmann, or the merger of Chrysler and Daimler, or the crowning disaster of Royal Bank of Scotland’s takeover of ABN-Amro – all either collapsed or were written off at huge cost to all involved. Yet the moth-to-candle rush to find new deals continues: the FT reports that global M&A deals announced in the first quarter of 2015 were worth $811 billion, the highest level of M&A activity since 2007.

The questions that come to mind are why do these deals fare so badly, and why do companies persist in doing them?

A merger is what usually happens after an acquisition (although not always – a company might run an acquired business at arms length without trying to merge operations, as Tata of India for example does with Jaguar Land Rover). And it is the merger part of M&A that goes wrong. Turning two companies into one always turns out to be far more difficult than foreseen.

One reason for this is that companies frequently do not really understand what they are buying. Although firms pay millions to advisors for ‘due diligence’ which is the process of examining the books of any business they have in their sights, due diligence frequently proves insufficiently diligent. This at least is the explanation given by the US technology company Hewlett Packard which is now claiming that more than half of the $11.1 billion it spent buying the British software business Autonomy in 2011 was actually wasted.

But the biggest misunderstanding is about the whole concept of buying a modern business. Companies used to be made up mainly of things like factories and machines. Now that has changed – the most valuable businesses are really collections of talents and intellectual property and brand equity, the so-called ‘intangibles’. It is estimated that the average proportion of intangibles in the valuation of a business has risen from 17% in 1975 to over 80% today.

The problem here is that intangibles are rather volatile elements. The record shows that talented people detest the culture clash that follows a merger, and tend to leave (taking clients or customers with them), while the accompanying turmoil tears the brand to shreds. The very process of executing a merger more often than not destroys the value of that merger.

There are exceptions. Mergers that are about capturing resources – as in the energy or commodities businesses – have at least a working chance of succeeding. Some modern technologies only become really profitable when they achieve critical mass and that may mean buying up competitors. But exceptions only test the rule, and the rule is that sooner or later, most acquisitive companies will end up experiencing buyers’ remorse.

That brings us to question number two, which is: why do they do it?

Some companies do it because they are run by people with monstrous egos. Some companies do it because they genuinely believe that they are different, that they can execute the merger without trauma. But most do it for one very simple reason: they are told to.

Where the telling comes from is difficult to pin down. Shareholders big and small, strategic and financial advisors, the impersonal dictates of the market, they all play their part. They tell companies that what they want is growth, growth of sales and growth of profits. And it is very often the case that big companies are not and are never going to be in a rapid growth phase. So where will they get growth? Answer: buy it.

But the search for growth is not the main reason that the financial sector is so keen on companies buying other companies. The main reason is that there is a lot of money to be made from the process.

First off there is the hunt, the bid and reply process as one quoted company stalks another (if the deal is contested). It used to be a rule that hostile bidding depressed the aggressor’s share price and pushed up the price of the quarry, but that went out of the window in the boom years before the crash and it doesn’t seem to have come back.

Now there are profits in backing the hounds and the fox. There is nothing that investment managers like more than a moving story – a ‘special situation’ as the professionals call it – because a moving story is a story you can play for profit. Boring old companies that never do anything but stick to their knitting might make you decent returns over the very long term, but in a ‘special situation’ there is overnight money to be made.

Less risky but hardly less profitable are the fees that M&A advisers make from deals. Advisers may be law firms, or large accountancy groups, or specialist takeover advisory firms, but they are most likely to be investment banks. The fees for M&A transactions are very attractive (and the dearth of them until things began to pick up in the last 12 months or so is one reason why banks have done so poorly in recent years).

These fees come in myriad forms, but there will usually be a ‘work fee’ that is paid whether the deal is struck or not, and then a much bigger scale of fees depending on the value of the deal. Fees are usually calculated on some variant of the ‘Lehman Rule’ which is an adjustable concept but which says in essence that the advisor will receive a series of staggered percentages of the total deal value; the smaller the deal, the bigger the percentage.

But don’t run away with the idea that fees for really big deals are some kind of bargain. The biggest acquisitions may win advisors fees equal to 1-2% of the total deal value. So for a really big acquisition like the Shell-BG deal which is worth $55 billion, advisory costs could be anything up to $1 billion. You heard correct: a thousand million dollars’ worth of fees.

It is not too difficult to see why these deals have a way of making their own momentum; there are simply too many people who stand to gain from the corporate churn. History says ‘please, please don’t do it’ but business typically does not have a rear-view mirror. Yesterday’s losses are never as inspiring as tomorrow’s gains.

So you may expect to hear of more mega-mergers soon. You can be sure to hear plenty about the efficiencies, the ‘synergies’ and the market logic of the latest wheeze, all of it designed to persuade shareholders that these crackpot plans are really a terrifically good thing. The aftermath – when the efficiencies turn into costs, the synergies prove to exist only in the imaginations of management consultants, and the market unpicks the logic with its customary ruthlessness – none of that will be such big news.

And yet, there may be change afoot. When the empire-building chairman of VW Ferdinand Piëch was recently manoevered out of the company, the share price immediately went up – investors said they were glad to see ‘M&A risk’ taken out of the picture. Could it be that shareholders are finally waking up to reality? Could it be that the rumour is going round the turkey shed that there is a downside to Christmas? That would be an unexpected change that would make life duller and better.

Richard Walker is a journalist and communications advisor to financial companies.

This article is an exclusive for CapX, and is available for syndication. Please contact [email protected] to discuss details.