The M&A Trap: Overpaying for Synergies

Vikas Mittal

CEOs see mergers and acquisitions (M&A) as strategic moves that can drive growth and enhance market power. However, many companies may be overpaying for acquisitions and overestimating potential synergies, leading to poor post-acquisition financial performance.

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Study

This study examined 2,352 M&As from 1980 to 2018 involving U.S. public firms. Each deal had a transaction value greater than $10 million, and the analysis focused on completed deals.

Main Measures Used: The primary measure introduced was the Implied Return on Equity Improvement (IRI), a metric that quantifies the minimum improvement in the target’s post-acquisition return on equity (ROE) that the acquirer must achieve to break even on the acquisition purchase price. IRI looks at metrics such as ROE growth, restructuring costs, and the likelihood of goodwill impairments.

Analysis: The study used econometric regression models to analyze the relationship between IRI and the acquirer’s post-acquisition performance, controlling for various deal and firm characteristics.

What the Study Showed
– On average, an acquirer must achieve at least a 38% return on equity to break even on the purchase price of a company. In other words, the IRI is a whopping 38% for the 2,300+ deals in the study’s sample.

– Deals with a high IRI were associated with worse financial outcomes for the acquirer. These included: on average, 11% lower ROE growth over three years, higher restructuring costs post-acquisition, higher frequency and magnitude of goodwill impairments.

– On average, acquirers tend to overpay for targets and/or overestimate expected synergies.

– Commonly used metrics like EPS accretion/dilution and announcement returns do not reliably predict the acquirer’s post-acquisition financial performance.

Key Takeaways for CEOs

Don’t overestimate the contribution of an M&A transaction: Most M&As require exceptionally high returns (38%) to justify the prices paid. Most companies overestimate the benefits, synergies, and value of an M&A overpaying for targets.

Metrics Can Be Misleading: Traditional metrics like EPS accretion or announcement returns to gauge the success of an acquisition do not predict long-term financial performance.

This research serves as a critical reminder: given the very high hurdle required for M&A success, CEOs should take a disciplined approach with realistic projections.

Citation:

Atif Ellahie, Shenje Hshieh, & Feng Zhang. (2024). Measuring the Quality of Mergers and Acquisitions. Management Science. DOI: 10.1287/mnsc.2023.01225.

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