Riding the wave

WHY mergers and acquisitions (M&A) come in waves is not fully understood. Companies’ fortunes are affected by the economy’s ebb and flow, but this does not seem enough to explain why merger activity crests and breaks so dramatically. Yet crest and break it does. In America there have been at least five merger waves, in which the number of deals swelled, peaked then tumbled. The first, in the 1920s, ended with the onset of the Great Depression. It was less obvious why the following ones—in the 1960s and then in each decade since 1980—were so strong. Now, say some experts, a powerful sixth wave is forming.

The evidence is far from conclusive. A spate of deals earlier this year, including American Airlines’ announcement that it and US Airways would fly off together (a plan now delayed by the antitrust authorities) and the swallowing of Heinz by Warren Buffett’s Berkshire Hathaway, had wave-watchers arguing over whether this was the start of something big. Then there seemed to be a bit of a lull until the $35 billion combination of two advertising giants, Omnicom of America and Publicis of France, was announced in July, soon put in the shade by Verizon’s $130 billion buy-out of Vodafone’s stake in its American mobile-phone interests, unveiled in early September. Worldwide, the value of M&A deals in the first nine months was only slightly higher than during the same period last year.

Nevertheless, “We have now entered the third phase of the M&A wave, when we can expect the number of deals to rise fast,” argues Peter Clark, who has written, with a fellow academic, Roger Mills, a new book, “Masterminding the Deal”. Drawing on a wealth of academic studies, it argues that merger waves have four distinct phases, which are mostly a reflection of changing business confidence. As spirits rise in boardrooms and on trading floors, so does the number of deals—and their cost.

In the first phase, usually when the economy is in poor shape, just a handful of deals are struck, often desperation sales at bargain prices in a buyer’s market. In the second, an improving economy means that finance is more readily available and so the volume of M&A rises—but not fast, as most deals are regarded as risky, scaring away all but the most confident buyers. It is in the third phase that activity accelerates sharply, because the “merger boom is legitimised; chief executives feel it is safe to do a deal, that no one is going to criticise them for it,” says Mr Clark.

This is when the premiums that acquirers are willing to pay over the target’s pre-bid share price start to rise rapidly. In the merger waves since 1980, bid premiums in phase one have averaged just 10-18%, rising in phase two to 20-35%. In phase three, they surge past 50%, setting the stage for the catastrophically frothy fourth and final phase. This is when premiums rise above 100%, as bosses do deals so bad they are the stuff of legend. Thus, the 1980s merger wave ended soon after the disastrous debt-fuelled hostile bid for RJR Nabisco by KKR, a private-equity fund. A bestselling book branded the acquirers “Barbarians at the Gate”. The turn-of-the-century boom ended soon after Time Warner’s near-suicidal (at least for its shareholders) embrace of AOL.

The trouble with mergers

As with unions between Hollywood stars, corporate marriages all too often end in tears. Messrs Clark and Mills reckon that as many as two-thirds of all mergers and takeovers fail, meaning that they do not deliver the benefits promised when the deal is struck. Much of this failure takes place during the third and fourth phases, when dealmakers’ exuberance is at its most irrational. Mr Clark reckons that once a buyer pays a premium of more than about 40%, the chances of a profitable marriage fall significantly.

Although many of the one-third of deals that do succeed happen during the first two phases of M&A waves when the premiums paid are lower, it is still possible to find astute dealmaking well into the later phases, which together last around five to six years. The likelihood of a deal delivering economic benefits is greatest when the goal is to cut costs by merging two similar firms. Encouragingly, this seems to be the focus of most of the current speculation about future deals. Rumours abound that further consolidation will take place in industries such as advertising, airlines, media, pharmaceuticals and telecoms equipment. In September Société Générale, a bank, published a list of what it considered to be likely deals, including brewing giant AB InBev buying a rival, SABMiller, and BHP Billiton, a mining company, acquiring Mosaic, a producer of potash, a commodity in which BHP is already big.

Whether the current swell turns into a genuine merger wave will depend in part on the banking industry. It has plenty of opportunities for consolidation, but also much post-crash risk-aversion among managers and scepticism among regulators. In this and other industries there has so far been little talk of “strategic” or “transformational” mergers, often euphemisms for when a company buys its way into an unfamiliar business, and thus a sign of froth forming. Some fancy prices have been paid recently for tech firms—such as Google’s purchase of Waze, a traffic-mapping firm, and Yahoo’s takeover of Tumblr, a blogging service. But the target firms were tiny compared with their buyers.

Have the lessons of merger history been learned? In his annual letter to shareholders of Berkshire Hathaway in 2008, Mr Buffett described the trouble even he had making a successful merger by quoting Bobby Bare, a country singer: “I’ve never gone to bed with an ugly woman, but I’ve sure woken up with a few.” Surfers’ spirits being what they are, if a fresh merger wave is indeed gathering strength, like the previous ones it will surely bring out the daredevil instincts in bosses. A few will ride its crest; others will be tossed into a cold and unforgiving sea.

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