The main job of CEOs of big corporations is to allocate capital. Few of them – having grown up in sales or product development – know much about it, even if they mean well. So it’s no surprise that they waste a lot of the company cash. Perhaps the biggest area of waste is in overpriced acquisitions of other companies.
I’ve written in the past about how value is destroyed by companies overpaying to buy back their own shares. This is a particular problem in the US stock market, where buyback volumes are much larger than elsewhere. In turn that’s due to terrible management incentives. (For more see here and here.)
Most buybacks happen at the absolute worst time – when stocks are at their most expensive. But there’s another area where corporations also waste huge amounts of money at the worst time: acquisitions of other companies.
Mergers and acquisition announcements are always tarted up with language that makes them sound like good news. They are “strategically compelling”, lead to “dominant market share”, are underpinned by “substantial synergies” etc etc etc.
But there’s rarely enough focus on the financial side. Namely, whether the acquirer is paying too much for all the supposed benefits.
I’ve seen this process up close from the inside when I was in the global strategy team at UBS (now UBS Group). Part of the team worked full time on M&A deals to grow the bank. I was involved in certain deals, but when I wasn’t I always knew what they were up to.
Despite being an investment bank – and therefore supposedly stuffed full of people who should know better – UBS used to routinely overpay for acquisitions. “Strategic imperative” – or corporate brown nosing by underlings – trumped financial good sense almost every time.
In the name of empire building and global market share, UBS wasted tens of billions of dollars of shareholders’ money on M&A during the 15 years that I was there. (I’m glad to say that they do a lot less of it these days.)
It turns out that “M&A” (mergers and acquisitions) is the area that uses up most company cash. I’ll use some charts from an October 2015 report by Credit Suisse, an investment bank, on capital usage in the US.
You can see straight away from the following chart – which breaks out uses of company cash – that M&A is consistently the largest destination for funds.
You’ll also notice how M&A’s share peaks at the same time as market tops, when confidence is riding high. In the chart, look at the late ‘80s, late ‘90s, 2005/2006 and…well…now.
This next chart shows a similar story: dollar amounts of M&A over the years, and those amounts as a percentage of corporate top line sales dollars.
Again you see the spending peaks coincide with market tops. Companies like to buy their competitors when they have the worst price – meaning the highest valuation multiples.
At the same time, corporations pay a pretty consistent premium to market price when they do deals. On average they pay 43% above market price to persuade target shareholders to sell. The theory is that the premium is justified (and more) by “synergies” in the merged company: cost cuts from closing/merging departments and offices, and new sources of revenues.
Of course synergies aren’t always achieved, but sometimes they are – or are even exceeded. But that aside, putting this together we see that companies pay fat premiums whatever the market conditions, but they are most likely to do acquisitions when markets are most expensive, and M&A is the biggest use of company cash.
In other words – over time and across the whole market – M&A is the biggest waste of company cash. It’s even bigger than the money down the drain from overpriced stock buybacks (see links above).
Clearly this is highly relevant for investors.
When M&A volumes are high it’s usually a sign that markets are overpriced, and a crash could be around the corner. If you notice a lot of big acquisition announcements then that could be a really bad sign.
It also means you should be cautious about investing in companies that do a lot of acquisitions. There are rare exceptions, but in most cases it means they are wasting vast amounts of your money.
Stay tuned OfWealthers,