Merger Monday and the Destruction of Wealth
[This article was adapted from a talk delivered at the Mises Circle in Houston, Texas, January 22, 2011.]
The stock market has been on a tear and it's all about mergers and acquisitions (M&A).
Last year ended up being a blockbuster for global mergers and acquisitions, with the total number of deals and values both rising by over 20 percent for 2010, hitting $2.4 trillion. Private equity buyouts meanwhile rose 7.2 percent, marking the strongest year for buyouts since 2007. Activity in M&A more than doubled in Australia; the Asia-Pacific region saw M&A deal value reach its highest value on record; and M&A deals also jumped 37 percent in Europe.
But of all regions, it was the emerging markets (EM) that posted the most impressive year. In 2010, the EM group saw 2,763 deals, worth approximately $557 billion. That marked a 20 percent increase in deal volume and a nearly 60 percent jump in total deal value.
But it wasn't exactly deals, deals, deals here in the States. The total value of American M&A only rose 3 percent year-over-year. But now M&A talk is really heating up in the United States.
The Fast Money Traders on CNBC say M&A is a major market theme — in tech, retail, mining, even deals in the financial services and real estate. "We would be remiss if we didn't disclose that we are somewhat surprised by the speed at which M&A transaction multiples have improved toward the sellers' favor," Keefe, Bruyette & Woods said in a research note concerning bank mergers. "We believe the market may be signaling that the buyers are being overly generous in sharing the economics with the sellers this early in the cycle."
Byron Wien, vice chairman of Blackstone Advisory Partners, listed as one of his "Ten Surprises for 2011," "Merger and acquisition activity becomes intense and the market reaches a blow-off euphoria."
With the announcement of AOL buying Huffington Post for $315 million, February 7 was referred to as Merger Monday. Danaher also announced it was buying Beckman Coulter for $6.8 billion, while oil driller Ensco Plc said it would buy Pride International Inc. for $7.3 billion.
But every Monday in 2011 has seemed liked "Merger Monday."
Jack Ablin, who is chief investment officer with Harris Private Bank in Chicago, says that "investors are coming in with the attitude, if these business leaders are confident enough to buy other companies, then I'm confident enough to buy stocks."
So what's driving M&A other than CEO ego?
First of all, it's cheap money. Wall Street began to fall apart in the summer of 2007 with the M2 money supply standing at $7.3 trillion. The Fed has hit the monetary gas — we've had TARP, TALP, and who knows what all, and by November of 2010, M2 was just short of $8.8 trillion, a more than 20 percent increase.
The prime lending rate was 8.25 percent back in the summer of 2007; now it's 3.25 percent. Six-month Libor (the London interbank offered rate) was 5.37 percent in July 2007; last month it was 45 basis points. No wonder someone on CNBC said recently that at these low interest rates, all of these "deals" (mergers and acquisitions) will be accretive to earnings.
A lot of deals will work on paper with rates this low.
Second, firms have lots of cash on their balance sheet and it's not earning anything. US treasuries with less than a year term are kicking off 13 to 27 basis points. Bank CD rates are somewhere around 1 percent for 12 months.
Rates are not low because people are delaying consumption and keeping high cash balances. It is the central bank that is keeping rates low, thinking businesses will begin borrowing and then start hiring. So rates are low, and everyone with cash from corporate CEOs to retirees wants to earn something besides 1/2 percent.
CEOs especially have money burning a hole in the pockets of their corporate balance sheets. They could pay the money out to current shareholders in the form of dividends, but they must figure, "what would the shareholders do with the money?"
The CEOs could hire more people and produce more goods and services, but, no matter what the Business Cycle Dating Committee of the National Bureau of Economic Research says, it's still a recession. Demand isn't that good. People are expensive to hire and especially to fire (if you can fire them at all).
Finally, there is increased government interference. Professor Peter Klein has found that firms make acquisitions when faced with increased uncertainty, citing regulatory interference and tax changes as major causes of uncertainty. When faced with increased regulatory interference, firms respond by experimenting, making riskier acquisitions — and consequently more mistakes.
Klein found that unprofitable acquisitions tend to come in industry clusters and that these clusters are likely to arise from intensified regulation. So, while money's cheap and government keeps getting more intrusive, CEOs figure, "Let's roll the dice and buy another business."
But according to Max Landsberg and Dr. Thomas Kell at the consulting firm Heidrick & Struggles, 74 percent of mergers fail. "Two-thirds of the newly formed companies perform well below the industry average," according to the Harvard Management Update. Although "up to 70 percent [of mergers] failed to create value, it seems clear that the end is not yet in sight," claims Financial Executive. And the Journal of Property Management says "60 percent to 80 percent of all business combinations undergo a slow, painful demise."
While CEOs think that when they do a deal two plus two will equal five, the fact is it often turns out that two plus two ends up equaling three.
Leadership consulting types claim a large company needs more effective leadership than a smaller one, and companies must consider their leadership capacity when confronted by change or contemplating an acquisition.
Human resources consultants say these mergers don't work because most executives manage the business integration but do not manage the human integration. Eager for the gains anticipated, they treat the acquisition like a series of financial reports, instead of organizations comprised of human beings.
Companies call these things "mergers," "acquisitions," "buyouts," and "takeovers," but what are they really doing? Buying stocks and typically at a premium to what the stocks had been trading for — forget volume discounts. These guys aren't just buying a cow or two but the whole ranch and paying a premium to the market price to boot.
Why is that? Unfortunately, government regulations cause this anomaly. Companies acquiring large blocks of stock in other companies must register their intentions with the government, thus alerting the market to those intentions. The government protects targeted firms from hostile takeovers and raises the price of buyouts.
And where do acquirers come up with the numbers that they pay for these acquisitions?
A former director of Coopers & Lybrand told author Mark Sirower, "Lotus is the culprit in failed acquisitions. It is too easy to assume anything you want in perpetuity without any understanding of the economics of an industry, and package it in a beautiful report."
In his book The Synergy Trap, Sirower says valuation models turn on three things: free-cash-flow forecasts, residual value, and a discount rate.
The cost of capital is integral to making these assumptions. The lower the assumed interest rate or cost of capital, the higher the price for the acquisition that the models will justify.
And if anyone is assuming today's Fed-induced microscopic interests rates will last forever, well, now would be the time to be selling instead of buying. Once interest rates go up, these valuation models will be blown up along with the government-employee pension-plan assumptions.
It's hard to make something work out economically if you overpay in the first place. And that is most often what happens. Companies overpay for the firms they acquire.
Or, as Warren Buffett put it in the Berkshire Hathaway 1982 annual report,
The Market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do…. A too high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.
Although he isn't writing about a stock-market boom driven by M&A, Ludwig von Mises could have been when he wrote that
the moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. There are stock exchange booms and stock exchange profits. Yet, the "producer" is dissatisfied. He envies the "speculator" his "easy profit." Those in power are not willing to accept this situation. They believe that production is being deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat of a crisis lies hidden.
Many mergers have been spectacular failures. Daimler Benz's had the great idea to buy Chrysler for $37 billion. The companies merged in 1998, and by 2007, Daimler Benz was selling Chrysler for just $7 billion.
Mattel bought the Learning Company for $3.5 billion in 1999. Less than a year later, the Learning Company lost $206 million, taking down Mattel's profit with it. The Learning Company was sold by the end of 2000.
Hedge-fund king Eddie Lampert bought Sears and Kmart in 2005 and merged them to create Sears Holdings. However, by 2007, Lampert was named the America's Worst CEO because the combination was floundering.
Quaker Oats purchased Snapple in 1994, for $1.7 billion. After just 27 months, the food giant sold Snapple for $300 million, losing $1.6 million for each day that the company owned the drink company.
Who can forget the AOL/Time Warner merger? In 2001, old-school media giant Time Warner consolidated with American Online (AOL), the Internet and email provider of the people, for a whopping $111 billion.
In May 2009, the CEO of Time Warner, Jeff Bewkes, announced that the marriage of AOL and Time Warner was dissolved. And now AOL is buying the Huffington Post for reportedly five times revenues. But we don't know the multiple to profits. If there are any at all.
With upwards of three-quarters of all mergers destined to fail, just what is the problem? Personnel and business culture-clash issues or just plain overpaying?
The Austrian School has determined that there are limits to the size of a firm. As much as those on the Left wring their hands about giant corporations taking over the world, it doesn't work out that way.
Mises famously determined that socialism can't function because there are no market prices in a socialist economy to distinguish more- or less-valuable uses of social resources.
But Peter Klein points out in his book The Capitalist and the Entrepreneur that Mises wasn't just talking about socialism. Mises was addressing the role of prices for capital goods. Entrepreneurs make guesses about future prices and allocate resources accordingly to satisfy customer wants and turn a profit while doing it.
If there is no market for capital goods, resources won't be allocated efficiently whether it's a socialist economy or otherwise. The market economy requires well-functioning asset markets. Without these prices, decision making is destroyed.
If one can't calculate and compare the benefits and costs of production using the structure of monetary prices determined at each moment on the market, as Joe Salerno points out,
the human mind is only capable of surveying, evaluating, and directing production processes whose scope is drastically restricted to the compass of the primitive household economy.
one cannot play speculation and investment. The speculators and investors expose their own wealth, their own destiny. This fact makes them responsible to the consumers, the ultimate bosses of the capitalist economy.
Murray Rothbard extended Mises's analyses to considering the size of firms, and the problem of resource allocation under socialism to the context of vertical integration and the size of an organization. He wrote that the
ultimate limits are set on the relative size of the firm by the necessity of markets to exist in every factor, in order to make it possible for the firm to calculate its profits and losses.
To make implicit estimates, there must be an explicit market. "When an entrepreneur receives income, in other words, he receives a complex of various functional incomes," Rothbard wrote. "To isolate them by calculation, there must be in existence an external market to which the entrepreneur can refer."
As firms get too big, economic calculation gets muddied because firms do not receive the profit-and-loss signals for their internal transactions. Managers are lost as to how to allocate land and labor to provide maximum profits or to serve customers best.
As these firms grow (especially by acquisition), one part of the company is often the provider and another part of the company is the customer, yet there are no market prices to allocate resources efficiently.
Economic calculation becomes ever more important as the market economy develops and progresses, as the stages and the complexities of type and variety of capital goods increase. Ever more important for the maintenance of an advanced economy, then, is the preservation of markets for all the capital and other producers' goods.
Professor Klein makes the point that
as soon as the firm expands to the point where at least one external market has disappeared, however, the calculation problem exists. The difficulties become worse and worse as more and more external markets disappear, as [quoting Rothbard] "islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc, become greater."
When firms expand, company overhead expands. And there is difficultly in allocating overhead or any fixed cost for that matter amongst various divisions of a firm. "If an input is essentially indivisible (or nonexcludable), then there is no way to compute the opportunity cost of just the portion of the input used by a particular division," explains Klein. "Firms with high overhead costs should thus be at a disadvantage relative to firms able to allocate costs more precisely between business units."
You know what overhead looks like. It's what Scott Adams describes as organizations "riddled with hamster-brained sociopaths in leadership roles," sitting around having meetings and looking at Powerpoint presentations. M&Ms kill productivity — not the candy: managers and meetings.
Too much management is required when firms get too big. If managers knew how to manage, there wouldn't be dozens of new management books constantly for sale — like Who Moved My Cheese? Who Made My Cheese?, Who Moved My Secret?, Who Moved My Soap?, and Who Moved My Church?.
The results of CEO buying sprees spurred by cheap Fed-produced money and credit are not new jobs and new products that make our lives better. These corporate shopping extravaganzas are just wasteful malinvestments that destroy capital.
Federal Reserve monetary policy over the last couple decades has not produced real economic growth but instead bubble after bubble — with each bubble (or each group of contemporaneous bubbles) being bigger in aggregate and more damaging than the one that preceded it.
As economist Kevin Dowd explains, these bubbles destroy part of the capital stock by diverting capital into economically unjustified uses. The central bank's artificially low interest rates make investments appear more profitable than they really are, and this is especially so for investments with long-term horizons, i.e., in Austrian terms, there is an artificial lengthening of the investment horizon.
And there is nothing more long term than buying a company, which is not just a group of employees and the current inventory of products or services but a package of previously made, long-term capital investments.
"These distortions and resulting losses are magnified further once a bubble takes hold and inflicts its damage too: the end result is a lot of ruined investors and 'bubble blight' — massive overcapacity in the sectors affected," Dowd explains. "This has happened again and again, in one sector after another: tech, real estate, Treasuries, and now financial stocks, junk bonds, and commodities — and the same policy also helps to spawn bubbles overseas, mostly notably in emerging markets right now."
The Fed's printing press is destroying the capital base of the American economy in so many ways that most don't realize.
Savers are punished and encouraged to risk capital on ventures that don't make economic sense. And CEOs, fooled by the faulty assumptions buried in their valuation models, see cheap money as the path to building empires.
However, these empires inevitably crumble and destroy precious capital in the process.