2019's mega-mergers: What is really driving shareholder wealth creation?

“Finally, knowledge of the source of takeover gains still eludes us.” (Jensen & Ruback, 1983)

It is a known fact that global economic development is a driving force for international mergers and acquisitions (M&A) activity. For the 4^th quarter of 2019, Bloomberg estimated a 19% GDP and a

Figure 1. Global dealmaking numbers. Reprinted
from Financial Times, by E. Platt, J. Fontanella-Khan, L. Noonan
& A. Massoudi, 2019, https://www.ft.com

12.5% policy interest rate depreciation compared to the 3^rd quarter. Taking this data, the further ongoing global political uncertainty due to Brexit and several market events like the cancelled multi-billion tobacco merger between Altria and Philip Morris into consideration, it does not seem surprising that the global M&A activity has fallen 11 per cent by the 3^rd quarter 2019 in comparison to the previous year, presenting a 2 year low in terms of deal value (FT). Although those numbers may not directly imply prosperous business activities, 2019 was still characterized by several US publicly listed mega-mergers: The $89.5bn purchase of the pharma company Celgene by its direct competitor Bristol-Myers Squibb, the $88.9bn armaments concern merger between United Technologies and Raytheon and lastly, the $86.3bn fusion between the pharma giants AbbVie and Allergan. It seems obvious that one could believe the former mentioned economic and business developments have put pressure on the performance of the executed multi-billion-dollar mergers. In the following, I want to explore the actual short-term historic performance of 2019’s two biggest deals, taking into consideration major deal characteristics and furthermore, discussing possible alternative managerial firm-specific value drivers.

First of all, it is important to examine the research on historic M&A performance. The 1983 conducted meta-study by Jensen & Ruback delivered statistically significant evidence on shareholder gains or losses after takeovers, concluding that acquiring company shareholders make regular short and long-term losses while target company shareholders make significant gains in value. Moreover, empirical studies suggest that when it comes to M&A financing methods, share-based takeovers underperform compared to cash-based acquisitions (Fischer, 2017). Reasons for this may be due to deal value preciseness or acquiring shareholders’ retainment of company control. When looking at 2019’s two biggest deals now, the numbers paint a surprisingly different picture:

Figure 2. United Technologies (UTX) share price development.
Reprinted from Bloomberg, 2019.

The 5 months after each merger-announcement daily price data (Bloomberg) of each acquiring company suggest periodical positive geometric returns of 3.61% and 16.30%, respectively for Bristol-Myers Squibb and United Technologies. Taking into consideration the companies’ required capital return of the same 5 monthly period, calculated by the use of CAPM (See blog post from 03.11.19) with an overridden periodical beta, the 2 companies generate excess returns of 0.59% and 13.7%. Therefore, especially the United Technologies and Raytheon fusion created substantial short-term shareholder value, although the global economic state and conducted research might have implied different results. Additionally, the strong performance of both acquirers can not be explained in the context of M&A financing research as Bristol-Myers Squibb purchased with a well-balanced 53% to 47% Stock-Cash mix while United Technologies even financed its merger with a 100% stock payment.

Without doubt, my short analyses of those 2 recent mega-events in the M&A industry are due to its way too small number of observations not statistically representable at all. Although, they do symbolically represent a recent development in M&A research. While the study of specific deal characteristics like the aforementioned financing methods or political and regulatory effects have been researched for decades, more and more academics use a different approach, considering mainly firm-specific managerial characteristics for explaining shareholder wealth creation in M&A. “Extraordinary acquirers”, a paper published by Golubov, Yawson & Zhang in 2015, is one interesting example of this new school of thought. The three academics conclude that firm-specific fixed effects match, partially even overshadow, the explanatory power of important deal-characteristics. Going more into detail, they deduce that positive and negative acquirer returns are firm-specifically persistent over time and that they are also persistent under new managerial influences due to changes of the CEO. Golubov et al. explain those findings mainly by firm-specific organizational knowledge in form of M&A development teams and expertise in post-merger integration, by “bidder-specific synergies, […], derived from the nature of the firm’s assets or its business model that are particularly well-suited for acquisitions” and lastly, by prior success in acquisitions that may facilitate future M&A activities.

Unfortunately, qualitative analyses always bring the same problem with them: They allow academics to retrospectively understand events by the use of econometric methods, but they do not allow regular investors to form a quantifiable opinion on future events that may influence their actual wealth. Although, my small research on state-of-the-art developments on this topic implies the same results as my valuation-blog post from 01.12.2019: Even though the real-life application of many academic papers seems too complex, we should still learn from research and integrate major findings in our daily investment strategies. Looking at the present case of this blog again, acquirer performances of recent deals within the last 20 years or company characteristics like the availability of in-house M&A development teams are publicly available and it should be a matter of course for every shareholder to be in knowledge of such information when it comes to the question of investing or an approval of a possible future merger. 

Bibliography

Fischer, M. (2017). The source of financing in mergers and acquisitions. The Quarterly Review of Economics and Finance, 65, 227-239.

Golubov , A., Yawson, A., & Zhang, H. (2015). Extraordinary acquirers. Journal of Financial Economics, 116(2), 314-330.

Jensen, M. C., & Ruback, R. S. (1983). The market for corporate control: The scientific evidence. Journal of Financial economics, 11(1-4), 5-50.

The Greatest Money Maker: A critical exploration of his investment philosophy

“You look at Berkshire and you think of things like the furniture company or Dairy Queen, but when you look at where the massive profits and the cash generation is coming from, it’s really from the insurance business, it’s really from derivatives, it’s really from the investments that he is making on Wall Street […] there is a divide between what you see on one side, which looks very simple, and what’s actually happening behind the curtain” (Sorkin, 2009, 00:52:20).

Since its founding in 1955, there have been enough books, newspaper articles or blogs written about Berkshire Hathaway and its founder Warren Buffett, to keep a person busy for the rest of his life reading. Therefore, it seems unnecessary to summarize Buffett’s way of becoming the most popular investor of all time. Rather, I want to directly start analysing excerpts of what the 2009 published documentary titled “The World’s Greatest Money Maker: Evan Davis meets Warren Buffett” identified as Berkshire Hathaway’s investment principles and discuss them by taking into consideration academic research.

1. "Invest, don't speculate"

In the investment manager’s opinion, a clear distinction between speculating and investing in financial markets can be drawn. While the former describes simplified the act of “betting” on prices going up or down, the latter expresses the way of looking at the underlying asset itself and its future return. However, research suggests that there is a difference between the commonly shared definition of investing and speculating but it is a blurred line as speculation is neither defined in terms of time frame, risk level and expected return, nor in terms economic utility (Arthur, Williams & Delfabbro, 2016). Furthermore, it would be simply false to think of fundamentally analysed investments as purely rational decision with determined outcomes and even Benjamin Graham, Buffett’s mentor and source of wisdom, wrote: “some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone." (Graham, 2009, Chapter 1).

2. "You don't have to diversify"

Figure 1. Berkshire Hathaway's public holdings. Reprinted from
Yahoo Finance, https://finance.yahoo.com/

I want to remind again that this list of investment principles was created by the producers of the BBC documentary and the reason this fact is worth being highlighted again is simple: It is truly questionable if Warren Buffett would ever make this statement as it is scientifically proven that diversification has major advantages concerning the elimination of unsystematic risk (Markowitz, 1952; Statman, 1987). Moreover, the latest data of Berkshire’s current portfolio allocation shows that the holding invested in 20 publicly listed companies in addition to their private investments, clearly taking advantage of diversification effects (Yahoo Finance). There is a reason behind the saying that “Diversification is the only free lunch” and it is important to remind oneself that even the possibly greatest of all investors does not do everything different than the regular shareholder.

3. "Don't get into debt"

When it comes to the question of optimal capital structure, there is still disagreement among academics. Classical theories like  Modigliani & Miller (1958) state the irrelevance of capital structure concerning the cost of capital while more recent approaches like Kraus & Litzenberger (1973) manage taking into consideration observable market imperfections like taxes and behavioural aspects in form of asymmetric information to create a model that states an optimal debt to equity level for every individual company. Although the latter approach has drawbacks like, for example, the quantification of debt disadvantages through financial distress and therefore the actual determination of an optimal debt to equity level, it is still the more realistic and applicable approach. Hence, it seems quite ignorant to make such a bold statement like “Don’t get into debt” in the factual presence of tax advantages of debt. For the benefit of the shareholders, there is happening something different behind the curtains of Berkshire Hathaway: Recent research on Buffett's investment strategy revealed average leverage of 1.7 to 1, significantly increasing Berkshire’s investment return (Frazzini, Kabiller, & Pedersen, 2018). In conclusion, the documentary’s findings and the actual reality fall significantly apart again.

After only having criticised the documentary in this blog, I want to highlight that Warren Buffett is in my opinion unquestionably the greatest investment mogul on this planet and his portfolio performance and constant success over decades speak for itself. Therefore, it remains a mystery for me how he can provide investment principles like the “Don’t diversify” one, that surely worked for himself in the past but that are highly dangerous for regular investors who are no financial geniuses. If I am being honest, I have not read any books written by Buffett himself, hence, it is possible that the BBC production team came up with the presented principles on their own. In any case, it is this ubiquitous discrepancy between Buffett’s success and the way he presents himself, what he does and how he does it, that my opening quote and the whole documentary highlight so well: There is happening more behind Berkshire Hathaway’s curtains than outsiders believe and maybe they even have a reason to make people believe it is that easy. The truth is: It is not. 

Bibliography

Arthur, J. N., Williams, R. J., & Delfabbro, P. H. (2016). The conceptual and empirical relationship between gambling, investing, and speculation. Journal of behavioral addictions, 5(4), 580-591.

Frazzini, A., Kabiller, D., & Pedersen, L. H. (2018). Buffett's alpha. Financial Analysts Journal, 74(4), 35-55.

Graham, B. (2009). The Intelligent Investor, Rev. Ed. London: HarperCollins.

Kraus, A., & Litzenberger, R. H. (1973). A state‐preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922.

Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91.

Miller, C., Crossley-Holland, D. (Producers), & Sorkin, A. R. (Journalist). (2009). The World’s Greatest Money Maker: Evan Davis meets Warren Buffett [Motion Picture]. Retrieved from https://learningonscreen.ac.uk/ 

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 261-297.

Statman, M. (1987). How Many Stocks Make a Diversified Portfolio? The Journal of Financial and Quantitative Analysis, 22(3), 353-363.

The limits of DCF models and the need for alternative valuation methods

Figure 1. WeWork valuations. Reprinted from CNBC,
by A. Sherman, 2019, https://www.cnbc.com/

As the year 2019 is ending soon, it may be worth to take a look back on major events that happened on the international financial markets in the recent past. If I would ask investors what first came to their mind when recapping the incidents, surely many would come up with the WeWork case. In a summary, the telecommunication company SoftBank invested up to $10.65 billion (CNBC) in the loss-making office space renter start-up, leading to excessive value inflation that ended up with a $47 billion valuation in their most recent private funding round (FT). WeWork’s following IPO plans lastly collapsed under the scrutiny of the public markets, revealing the over-valuation and the tremendous misjudgement of financial analysts. But when it comes to incorrect valuations, WeWork’s case was not the only one in 2019. While the fitness equipment producer Peloton failed to convince it’s investors of their $8.2 billion (FT) valuation, trading at almost 15% below their offer price (FT) on the first trading day, the question that investors ask themselves at the latest since the crash of the Dotcom-Bubble, namely if there is any truth in financial valuations, is still a recent one.

Logically, if one doubts the correctness of financial valuations, one must doubt the commonly used valuation techniques which are mainly the discounted cash flow method (DCF) and the multiple analysis approach (Mukherjee, Kiymaz, & Baker, 2004). In the following, I want to shortly discuss uncommon points of critique on DCF models and give an overview of a strategic framework that can even be used by regular investors, in addition to traditional financial valuation.

First of all, when people criticise the use of discounted cash flow methods, they mostly see issues in the assumptions of static discount rates, inappropriate discount rates or the imprecise prediction of future cash flows, but never in the use of free cash flows itself. As there are no “perfect” markets in which companies only invest in positive NPV projects and return excess profit to their shareholders like Modigliani & Miller (1961) state in their residual dividend policy theory, it is questionable if the usage of free cash flow itself is an appropriate measuring unit. For example, 2 comparable companies that both have the same predicted future cash flows and discount rates should have the same valuation, even if one of both only spends its cash on increasing executive salaries and negative NPV projects while the other one is acquiring strategically suitable and highly efficient competitors. Taking this argument into consideration, the Dividend Discount Model would be a way more appropriate method of valuation as Dividends paid back to the shareholders can not be embezzled anymore, could one argue cynically.

Figure 2. Impact of WACC on Terminal Value. Reprinted from Financial Times,
by D. Keohane, 2016, https://www.ft.com/

A second DCF criticism that I want to highlight here is a highly topical one. Only a few years ago, not many people may have imagined that the base interest rate of several economically stable countries could be more or less zero, somehow even negative. This significant macroeconomically shift has a major impact on basic financial models like the capital asset pricing model and therefore also on DCFs. When the risk-free rate is approximately zero, WACC falls due to falling costs of equity. In this case, the anyhow hard to predict terminal value gets accountable for a higher proportion of the total NPV and therefore, a possible misjudgement has a greater impact on the total valuation. This issue is surely a commonly known one, although, investors and analysts should be aware of it as the impact of the terminal value and its faultiness is way greater than one could think.

Referring back to the recently unsuccessful valuations of WeWork and Peloton, it is not a secret that start-up valuations present the most complicated cases in practice. The simple reason for this is the lack of accounting information. Therefore, the state of the art academic research suggests shifting the focus from solely carrying out a financial valuation to taking into consideration modern frameworks of strategy theory. As Miloud, Aspelund & Cabrol (2012) suggest, modern start-up valuation should take place in the context of the structure of its market, stress out the firm’s valuable assets and inputs instead of possible future cash flows and examine the network and external relationships of the company. More precisely, statistically significant factors that correlate positively with the start-up valuation are I] Industry product differentiation, II] Industry growth, III] Founder with industrial experience, IV] Founder with managerial experience, V] Founder with start-up experience, VI] Team of founders, VII] Managerial key positions are filled, VIII] Number of alliance partners. The weak spot of the strategic framework is obvious: It always needs the so often and with justification criticised financial valuation. However, it provides an excellent benchmark for valuation if compared to peers that share general characteristics with your target and recently went public. Lastly, it has the same major benefit as discounted cash flow models: The investors or acquirer has to scrutinize the target as carefully as possible, has to be familiar with the business model and not only with the financials and therefore, he or she gets more and more of a personal feeling if the company may be the next unicorn or if it disappears within the next few years.

Professionals all over the world love the saying that “Valuation is an art, not a science” and, understandably, they repeat it as often as possible as it allows them to justify their mistakes. However, I think the saying is nonsense because art can never be judged as right or wrong while there definitely exists an unambiguous value for each existing company, we just often can’t tell what it is. I do not want to question the difficulty or complexity of business valuation but once again, I want to emphasize the importance of research on daily business as both should learn from each other instead of working in different worlds.

Bibliography
Miller, M. H., & Modigliani , F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433.

Miloud, T., Aspelund, A., & Cabrol, M. (2012). Startup valuation by venture capitalists: an empirical study. Venture Capital, 14(2-3), 151-174.

Mukherjee, T. K., Kiymaz, H., & Baker, H. K. (2004). Merger motives and target valuation: A survey of evidence from CFOs. Journal of Applied Finance, 14(2).