The Deal

Bum rap

Too often, Wall Street analysts don't give dilutive mergers much respect. They grow anxious that earnings will go down until the deal's synergies kick in.

글 Vicky Bindra and Eric Aboaf

First published on 2월 21, 2002
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Why do analysts tend to give dilutive mergers a bum rap? When a deal depresses the acquirer's earnings per share, deal raters worry the premium paid for the target company will make it harder to create shareholder value. They grow anxious that earnings will go down until the deal's synergies kick in. But our research indicates their fears are misplaced. When we analyzed financial service sector acquisitions that took place between 1998 and 2000 with price tags of $750 million or more, we found that dilutive deals boosted shareholder value twice as often as accretive deals, transactions that pumped up earnings per share. Twenty-three of the 54 deals in the sample were moderately or strongly dilutive—in other words, the target's price-earnings ratio divided by the acquirer's price-earnings ratio was greater than one. One year after the announcement, more than 60% of the dilutive transactions had added shareholder value; the stock price of the combined companies kept up with or outperformed the respective sector index. Only 39% of the dilutive deals destroyed shareholder value, with the combined companies trading their shares at a 10% to 30% discount from the respective sector index. Among the 19 accretive deals in our sample, the failure rate by the same measure was 58%. Only about 16% of the accretive companies succeeded in adding shareholder value above the sector index. These findings held up even though we calculated the target's P/E using the purchase price per share, which is usually higher than the trading price. So what really makes the difference in merger success? Based on interviews with chief executives and analyses of the pre- and post-acquisition performance of deals in our sample, we learned that diligence in executing four disciplines of merger valuation and integration trumps dilution. Dilutive dealmakers compensate for the extra risk that they incur when they pay a premium for a target company by being more careful when it comes to the following: Due diligence - knowing the target company and making sure the deal has a strong strategic rationale; Execution - quantifying and executing synergies; Negotiation - paying the right price; and Leadership - understanding management strengths and limitations. Analysts and shareholders assert more pressure on dilutive deals than accretive acquisitions, which typically escape strong scrutiny at shareholder meetings or by analysts. That's why chief executives usually prefer accretive deals, which can be a big mistake. Consider the dilutive Norwest Corp.-Wells Fargo & Co. bank merger in 1998, which outperformed the financial services index by 12% one year after the transaction closed. Norwest conservatively assumed the transaction would produce no revenue synergies despite its track record of cross-selling. Within that first year, however, not only did Norwest manage to sell its products through Wells Fargo's distribution channels, but in the process it fully realized estimated cost synergies of $650 million, about 4.2% of the combined company's costs. Norwest initially did not get credit for negotiating favorable terms. Yes, it paid a 9% premium for Wells Fargo, but at the time comparable mergers were commanding average premiums of 20%. Norwest's leaders had a good track record for merger integration. The company's 1996 acquisition of Franklin Federal Bancorp boosted shares 62% within 12 months. Norwest also has a successful sales culture, selling an average of four products per customer versus Wells Fargo's two. It nailed due diligence and execution of merger integration, and it did not overextend on price or overestimate its managerial capacity. Other dilutive deals that created value through diligence and disciplined integration include American International Group-SunAmerica Inc.; Fairfax Financial Holdings Ltd.-TIG Holdings; Chubb Corp.-Executive Risk Inc.; US Bancorp-Western Bancorp; Hartford Financial Services Group-Hartford Life Inc.; Washington Mutual Inc.-Bank United Corp.; and FleetBoston Financial Corp.-Summit Bancorp. Such adherence to merger disciplines appeared less often among accretive deals, which assume an immediate lift in earnings per share based solely on their financial structure. For example, Netherlands-based life insurance company Aegon NV pulled off an accretive acquisition in 1999 of TransAmerica, the diversified financial-services company. Despite the initial cheers on Wall Street, one year later the combined company under-performed its industry index by 10%. Where did it go wrong? Aegon's due diligence failed to consider that more than 40% of TransAmerica's operating income came from non-core activities—lending, leasing, real estate services—that did not yield significant synergies. Aegon overpaid for TransAmerica, shelling out a 35% premium when average premiums for comparable mergers were only 27%. On the execution side, Aegon failed to achieve expected cost synergies of $150 million. Although TransAmerica provided Aegon with a strong brand name, TransAmerica's life insurance operations had high expenses and limited growth prospects and did not provide Aegon with access to growth markets of the variable-annuity business. Our research shows that while deals can succeed when they exceed expectations on just one or two of the four key merger disciplines and meet expectations on others, deals that trail expectations on any one discipline—accretive or dilutive—typically fail to create value. So analysts who challenge dilutive deals inadvertently may do them a favor. By putting the dealmakers in the hot seat, Wall Street forces management to be more diligent in executing the deal, which improves the odds it will create value for investors. Vicky Bindra is a manager in financial services and Eric Aboaf is a vice president who helps lead the financial-services practice at Bain & Co. Both are based in New York.

Why do analysts tend to give dilutive mergers a bum rap? When a deal depresses the acquirer's earnings per share, deal raters worry the premium paid for the target company will make it harder to create shareholder value. They grow anxious that earnings will go down until the deal's synergies kick in. But our research indicates their fears are misplaced.

When we analyzed financial service sector acquisitions that took place between 1998 and 2000 with price tags of $750 million or more, we found that dilutive deals boosted shareholder value twice as often as accretive deals, transactions that pumped up earnings per share.

Twenty-three of the 54 deals in the sample were moderately or strongly dilutive—in other words, the target's price-earnings ratio divided by the acquirer's price-earnings ratio was greater than one.

One year after the announcement, more than 60% of the dilutive transactions had added shareholder value; the stock price of the combined companies kept up with or outperformed the respective sector index.

Only 39% of the dilutive deals destroyed shareholder value, with the combined companies trading their shares at a 10% to 30% discount from the respective sector index.

Among the 19 accretive deals in our sample, the failure rate by the same measure was 58%. Only about 16% of the accretive companies succeeded in adding shareholder value above the sector index. These findings held up even though we calculated the target's P/E using the purchase price per share, which is usually higher than the trading price.

So what really makes the difference in merger success?

Based on interviews with chief executives and analyses of the pre- and post-acquisition performance of deals in our sample, we learned that diligence in executing four disciplines of merger valuation and integration trumps dilution.

Dilutive dealmakers compensate for the extra risk that they incur when they pay a premium for a target company by being more careful when it comes to the following:

Due diligence - knowing the target company and making sure the deal has a strong strategic rationale;
Execution - quantifying and executing synergies;
Negotiation - paying the right price; and
Leadership - understanding management strengths and limitations.

Analysts and shareholders assert more pressure on dilutive deals than accretive acquisitions, which typically escape strong scrutiny at shareholder meetings or by analysts. That's why chief executives usually prefer accretive deals, which can be a big mistake.

Consider the dilutive Norwest Corp.-Wells Fargo & Co. bank merger in 1998, which outperformed the financial services index by 12% one year after the transaction closed. Norwest conservatively assumed the transaction would produce no revenue synergies despite its track record of cross-selling. Within that first year, however, not only did Norwest manage to sell its products through Wells Fargo's distribution channels, but in the process it fully realized estimated cost synergies of $650 million, about 4.2% of the combined company's costs.

Norwest initially did not get credit for negotiating favorable terms. Yes, it paid a 9% premium for Wells Fargo, but at the time comparable mergers were commanding average premiums of 20%.

Norwest's leaders had a good track record for merger integration. The company's 1996 acquisition of Franklin Federal Bancorp boosted shares 62% within 12 months. Norwest also has a successful sales culture, selling an average of four products per customer versus Wells Fargo's two.

It nailed due diligence and execution of merger integration, and it did not overextend on price or overestimate its managerial capacity.

Other dilutive deals that created value through diligence and disciplined integration include American International Group-SunAmerica Inc.; Fairfax Financial Holdings Ltd.-TIG Holdings; Chubb Corp.-Executive Risk Inc.; US Bancorp-Western Bancorp; Hartford Financial Services Group-Hartford Life Inc.; Washington Mutual Inc.-Bank United Corp.; and FleetBoston Financial Corp.-Summit Bancorp.

Such adherence to merger disciplines appeared less often among accretive deals, which assume an immediate lift in earnings per share based solely on their financial structure.

For example, Netherlands-based life insurance company Aegon NV pulled off an accretive acquisition in 1999 of TransAmerica, the diversified financial-services company. Despite the initial cheers on Wall Street, one year later the combined company under-performed its industry index by 10%.

Where did it go wrong? Aegon's due diligence failed to consider that more than 40% of TransAmerica's operating income came from non-core activities—lending, leasing, real estate services—that did not yield significant synergies. Aegon overpaid for TransAmerica, shelling out a 35% premium when average premiums for comparable mergers were only 27%.

On the execution side, Aegon failed to achieve expected cost synergies of $150 million. Although TransAmerica provided Aegon with a strong brand name, TransAmerica's life insurance operations had high expenses and limited growth prospects and did not provide Aegon with access to growth markets of the variable-annuity business.

Our research shows that while deals can succeed when they exceed expectations on just one or two of the four key merger disciplines and meet expectations on others, deals that trail expectations on any one discipline—accretive or dilutive—typically fail to create value.

So analysts who challenge dilutive deals inadvertently may do them a favor. By putting the dealmakers in the hot seat, Wall Street forces management to be more diligent in executing the deal, which improves the odds it will create value for investors.

Vicky Bindra is a manager in financial services and Eric Aboaf is a vice president who helps lead the financial-services practice at Bain & Co. Both are based in New York.